The answer to that question essentially depends on how confident you are that the increase in value will be achieved. It goes without saying that the more confident you are, the more you would be willing to pay. The more difficult questions are, however, how much would you be willing to pay at different levels of confidence for the expected increase in value, and how confident are you in achieving that potential value creation?
For example, if your company were generating a $3 million annual EBIT and commanding a 4 times EBIT multiple, and you were fully (100%) confident of increasing EBIT by 20% and that value multiple by one point to 5 times, what would you be willing to pay to get the $6 million increase in value? What would you be willing to pay at a 70% confidence level, or at 50% or at some other figure?
This piece attempts to help in that decision.
At a 100% confidence level you wouldn’t generally pay fully value – in other words you wouldn’t pay $6 million to get a $6 million value increase. That wouldn’t generally make rational sense. Given that capital has a cost, if you need to raise the capital to pay for the value increase, you need a return that is higher than your marginal cost of capital. If trading on a 4-times multiple, per the example above, you need to earn at least 25% pa on your investment. At a 5-times multiple this would be 20% pa. If on the other hand your business can fund the cost with its internal cashflows, it needs to earn a return at least equating to its opportunity cost – as the money could otherwise have been allocated elsewhere.
The chart below depicts the relationship between confidence in achieving the expected ROI (y-axis) and the expected ROI (x-axis).
Basis of calculation: If 100% = 20% pa expected return, then the expected return at an 80% confidence level would be 25% pa (100%/80% x 20%). Similarly, at a 50% confidence level, the expected return would be 40% pa (100% / 50% x 20%).
The decision (as to the minimum expected returns at different levels of confidence) however is more complicated than depicted on this formulaic chart. It requires you to give more thought to: what is the expected benefit, and what is the impact of the downside?
As regards, quantifying the benefit a few questions come to mind:
One is, without putting your business on the market, how can you reliably determine the extent of the value added? Given the nature of their approach, being comparative sales, many valuers are ill-equipped to determine value. That is because they don’t have sufficient information on the comparative sales to establish the factors that led to the value concerned. They essentially only know the industry, nature of business, revenue and/or EBITDA and the sale price. There are significantly more factors that determine the value of a business. That notwithstanding, even their core information is of questionable relevance. EBITDA and EBIT are insufficient as they do not reveal how much capex will be required and when, and the sale price can depend on the structure of the sale. For example, a sale price with an earn-out contingent on the achievement performance thresholds would justify a higher sale price. If those performance thresholds are not met, the sale proceeds could be a lot less than the stated sales price.
Another is, where you sold your business, did you get full value for it? Did you accept a lower price in return for extracting assurances, such as keeping your business as a standalone entity and not firing your loyal staff? And did you engage the right business broker for the job, and did they do a proper job? The approach to selling businesses of radically different sizes is materially different and the approach to selling businesses in some industries can also be very different to selling businesses in other industries.
A third question that comes to mind is, how do you quantify the longer-term benefits? As a business generates higher profits and commands a higher value multiple, more doors open for it. Its cost of capital reduces, which lowers its return threshold for pursuing growth opportunities, which in turn gives it more opportunities to pursue. It is also able to raise more capital – as more markets open to it – giving it further opportunities. At some point the banking sector will be willing to waive the need for personal guarantees from directors and shareholders. Then they can inject a lot more capital into the business without increasing their exposure to the business, which in turn presents opportunities the business would otherwise not have been able to pursue. Given these significant longer-term benefits, business owners can justify paying a lot more to increase the value of the business than the formulaic increase.
Another flaw in a comparative-sales based valuation is where a business may have wasted money or incurred costs the buyer considered unnecessary. These costs would have reduced its profits, which in turn could have shown it to have sold for an above-market value, while the buyer, after eliminating (adding back) those unnecessary costs would base its price determination on a higher level of profits, resulting it having paid a below market value. This distinction would generally be lost in a comparative-sales based valuation.
The other complication, as mentioned above, is: What will be the impact on the business and the business owner if, for whatever reason, the increase in value does not materialize or is materially less than expected? This could, for example, be due to unforeseen industry changes that are out of the business owner’s control. In this hypothetical worst-case scenario, would the money paid to increase the value of the business be ruinous for it? Would the payment be the ‘straw that breaks the camel’s back’? In such an extreme scenario it is more likely the business would have collapsed any way, and if you were concerned about such a scenario, it would be best for you to get out (sell) sooner rather than later. So, a more relevant question is: On a business-as-usual basis, what impact would payment for the expected benefit have on the business if that benefit was not realised? Would it survive? This is also an unrealistic scenario and so should be dismissed. You should rather consider the range of realistic value scenarios – pessimistic, most likely and optimistic – and ensure the business will not be fatally wounded if that pessimistic scenario eventuates.
If concerned about the adverse impact under the pessimistic scenario, you could consider various risk mitigating strategies. One is, to raise equity capital to fund the costs rather than using surplus cashflows or burdening the business with more debt. Similarly, you could negotiate to pay some or all the cost with scrip / shares. Another risk mitigating strategy is negotiating to pay a sizeable portion of the costs on success – after you are satisfied the value has been added. In such a case it would be reasonable to expect that you would need to pay more on success than if payment was to be upfront.
In conclusion:
While the chart is a useful guideline, the decision is more complex. It requires you to consider the position your business is in and requires you to have a good understanding of the factors that drive value for different classes of investors and perhaps even for different investors in the same class. Your business may, for example, be able to add a lot more value to one trade buyer than it would to another. Once you understand how different investor classes and different prospective trade buyers would determine the value of your business, you should be able to come to a reasonably justifiable value range for your business. Then use this basis for your decisioning. You will have a better understanding of the value of your business and a better understanding of what you need to do to increase that value.
————————-
R&M aims to offer its clients an outstanding expected return-for-risk. The expected benefit would generally be more than 20 times the cost of its fees, and its approach significantly reduces the risk for its clients. This it achieves through the following arrangements: 1) It does not seek up-front payments or commitments. It charges on an ‘as use’ basis for each module on which it is engaged. 2) While offering 25 modules, it does not require or even generally recommend that it be engaged on all of them. 3) It assists business owners determine whether to engage it on a module by posing various questions for the business owner to consider in relation to that module – this helps business owners decide whether, and if so to what extent, they will benefit from the module concerned. 4) It recommends that the business owner consider the module, implement strategies and otherwise do what’s preferred before engaging it to deliver another module – this is to ensure the necessary action is taken to increase value. 5) It generally recommends the program be delivered on a module per fortnight basis – so over about 12 months for all 25 modules.
Here is a link to R&M’s Advisory webpage, which provides more information on what R&M offers, why and how it goes about its business – https://www.rogersmorris.com.au/rm-advisory/ . An email address is provided for those who would like to explore what R&M can do for them.