EP 98: Business Value: Eye of the Beholder

I'm your host, Ed Mysogland. And today, I want to talk about business value. And the thing, the thing that I want to to focus on is different types of value. And a lot of the people that are that I'm working with, or that have contacted me over, certainly the last couple of years, there seems to be a disconnect over over value, not necessarily, not necessarily disagreeing of, of the value of their company. But how there can be different values depending on who is valuing the company. And that is the topic today I want to talk about value is in the eye of the beholder. And so I want to I want to focus on that. Let's go ahead and begin with talking a little bit about, you know, most businesses have a cost actions at a cost of equity capital, right? A cost of equity capital of between 20, and 30%. Alright, that's, but the problem that we're bumping into is that most business owners don't generate those types of returns. And you'll, you will have heard me say over and over again, that business value is is about growth, expectations and risk. And when we talk about earnings, we're talking about how much can I pay myself for someone to run my company? How much debt can I service, and how much of a return of an on my investment can I get, those are, those are the drivers of the value. And yet, business owners aren't able to generate those types of returns over the cost of capital. And what ends up happening is we get what's called a value gap, the value the the the value, the owners perception of value versus the buyers, you know, you have this delta between the two of them and where you find buyers that aren't, you know, that recognize, and we talk here in a couple of weeks, we talk to John Morello about drivers of value, and the buyers that I'm referring to or are citing that the business owners just don't take those returns and reinvest in, in the company. And as a result, we have, we don't have growth, we don't, there's, we don't have growth in a number of different in a number of different ways. Meaning that we're not reinvesting in equipment, we're not adding people, we're not entering new markets, we're not bringing out new products or services, those are the kinds of things instead what we're doing is we're just relying on on a standard earnings stream, and that creates some challenges. Alright, next, I think I want to reinforce that a business has has a ton of different values that are all right, depending on who it is. And when we're talking about valuation in in a sale environment, each respective buyer has their perception of risk, and that risk affects the value. So now, when we one of the things that and it just happened this week, where I was reviewing a business valuation, and it was what's called a fair market value valuation, and it was based on, you know, the principal substitution and, and the business owner, you know, and the appraiser and I, I mean for the purpose that they were saying it was right, but they took their fair market value appraisal, and they were bringing it to me from a market standpoint, and we had different differing opinions. And what I wanted to share was that there's a difference in how we approach that value and because they're looking at at public returns and applying it to private companies. So let's talk a little bit about those differences. So from a corporate structure, the public market is a C Corp. The Private Markets can be CSX sole proprietorship LLC lb there is no difference. The public markets are the value is is established by the market. And private markets value is established at a point in time. So for example, with the public markets, you're able to go to any, any, go to Apple, and pull up the stock. And you can see the value of that company right now, in with private companies, you have to have a buyer that ready willing and able to buy for you to determine what that market value is. For private markets we have, they're able to have public or they have access to public capital, meaning they can raise debt, just like that. But with private companies, they don't, they don't have access to that, and they have to get loans from various capital providers. So in public markets, the owners have have very limited liabilities, the private companies, the owners have unlimited liability. In public companies, the owners are well diversified, meaning there's all kinds of shareholders and private companies, owners tend to be concentrated, meaning there's there's a few of them. So in public markets, there's professional management, and private companies, there's owner management, the company and public markets, we have an infinite life that the company is built to have an infinite light. And then private companies, you tend to see businesses only lasting a generation. In public markets, we talked about liquidity, liquidity is meaning that I have the ability to convert my my shares into cash within three to five days, in private markets, you have to actually sell the company and that normally takes six to 12 months, if it's going to sell it all, in the private, or in the public markets. Profit is is the goal. Not that every business is profit goal, but theirs is profit maximization for the shareholders is for private companies. It's personal wealth creation. Those are that's how how the differences between the two. So and the biggest, the biggest takeaways I want you to do. You know, as you look at Eric, as you think about what I just said, it really comes down to liquidity and risk, right, both and access to capital, those are the three drivers. So public markets have, you know, they're they have, the risk is diversified, they have access to capital, and their their intent, their, their intent is to grow the business and, and as well as the liquidity, they are able to, to take your whatever fractional interest you might own, they can you can create liquidity three to five days, and private in private capital markets, or I'm sorry, in private companies, you cannot. So now let's talk a little bit about the types of value. So, so value today, you know, it's a historic and forensic. And this is this is

Ed Mysogland  8:31  
Rob Slee of private capital markets, he had a, he, he really did a great job at identifying how this how this plays out as far as value is concerned. And we're going to talk about what he calls value worlds here in a second. But today, we're looking at compliance oriented valuations, and some are measured with singular certainty. Those are, that's how value is defined today. Now, as I mentioned to you, he has he had a great way of looking at as far as he called them value worlds. And, and according to his, what he called the value world theory, the the motive leads to the reason for the appraisal. The reason for the appraisals selects the value world, and the private business value is relative to the world in which it's viewed, and therefore the private company has dozens of correct values at any point in time. So as we were talking about value worlds, the different types of value and I don't know whether that's a value world as the appropriate term or not, but let's just let's just say these are the different types of value. So you have market value, that's the world I live in. So that's what the open market says that the business is worth and and we use the asset That approach the assemblage of assets, we look at financial buyers, and then we look at Synergy, and those are our, the, the values that could be under market value. So in other words, what what we call strategic or synergistic value, we look at asset value, you know, what, what is it for a financial buyer? And so that's what we use for market value. And that's probably the, if you're listening to this podcast, that's probably the valuation you want is, what does this company? What is your company worth on the open market? Then we move into fair market value? And that's what the IRS and courts say it's worth, you have the owner, the owner value, which is what clearly what the owner thinks the business is worth, you have investor value? What if you're raising money, what does the investor say it's worth, you have collateral value, what's the bank say it's worth. And then you have insurable value, no startup value, public and fair value, fair value, meaning that there is no, there are no discounts. And so you can, you can see that there are so many different types of value, and all of them can be right based on who who is the author of the valuation, and, and what its purpose is for. So keep, keep in mind that that's what we're what we're, we're looking at. So the authority of the value, so in my case, the market value, I tend to be the authority because I'm in it, I'm the one seen, what businesses are selling for. And again, by virtue of taking the business through the process, we're able to determine what market value is, regardless of what we think what we believe that the business is worth in the process is the expert in our world. And so the, you know, when they're in these different types of value, in the case of, of competing authorities, the one with the most compelling argument wins, in my case, and let me just give you an example. You know, when we rather than us what what happened with me, I want to talk about a another expert witness. And let's just say it was it was for equipment. I did an extensive analysis on on a bunch of equipment, and the judge. Now the judge was really impressed with all the work that I had done. And here's this guy that does not have the credentials I do. And he walks up and he said, he takes the stand. And he says, Judge, you know, I know that the work that this guy did is, is thorough, but I'm telling you, I was at an auction two days ago, and this is the value of this equipment. And he brought, he brought the evidence. And despite, despite all the work that I had done, and for me, it was a compelling argument. He had real he had his information was superior, even though my credentials were better than his. And so, again, he had the compelling argument. And that's my point, is that depending on who is who is the authority, or the arbitrator of of that value? They're the ones that determine, you know, who wins? So you need to also remember that, with each of these types of value, the earning stream differs. All right? So an owners value is when we're looking at just that, how much benefit to the owner and then we then we use valuation from there. And then depending on who the buyer is, we've talked about this a number of times with the guests that we've had on is risk, risk differs depending on who the person who the person is, and what what this particular reason for value is. So a synergistic purchase. The earnings would be different because I may not need all of the, the the back room because I'm going to merge it in. I may not need the facility because I have excess space. So my so for me, I'm picking up these are the earnings, the earnings savings that I'm picking up. And since we're in the same business, we don't have the same risk that an individual buyer would have. So the earnings expert or the earnings, the benefit stream or the earnings differs Depending on who the buyer is, and then the return differs depending on the risk. And now we move into the highest price. In my world, the highest price is market value for private companies, and, and it is for the assets or the stock of the company. And we look at, at, you know, the asset, and that we have the cop the the assemblage of assets, you know, who's the who's the buyer for those assets, we look at financial buyers, and we look at synergistic buyers, those are the three types. And who are who are those authorities, those are the authorities or m&a Folks, and a business appraisers. And that's how we look at, and why we're the authority because we are the boots on the ground. And, you know, when we let's just talk, and we were just talking about the asset, you know, the asset approach? Well, the asset, you know, it's just an it is a it is an operating business without without goodwill, and it is a it is a challenge under the asset value, because you're you're not getting credit for any kind of goodwill. And that creates a problem because especially in in service type businesses, that is the essence of the value of the company. So when we move into the income stream, let's talk a little bit more about that when we talk about the income stream or the the the earnings versus the multiple. So financial incentives, just value that the earnings stream is is the earning stream times the multiple and everybody uses EBIT da so earnings before interest, taxes, depreciation, amortization times an acquisition multiple to stream, the earnings stream differs depending on who that buyer is. And then the buyer brings the multiple, why is the buyer bring the multiple, hopefully, by now you've you've learned from me that the buyer, the risk profile of each buyer differs. So regardless if it's a company or a person, that that, that that risk, is there risk you, we can't quantify it. And that's part of my problem with fair market value appraisals that show up at my doorstep, is they're saying, Well, you know, given the alternative investments to where this, you know, we're where a hypothetical buyer can invest their business they're earning or their return on investment needs to be 13.75%. Well, that's nice. But that's not real world. In our world, it's, it's, each buyer has their own risk profile, you can say it's a hypothetical buyer, based on all kinds of other all kinds of other alternative investments. But in in our case, it is not the case. In our case, we're we're like I said the process is the expert and value. Alright, so now

Ed Mysogland  18:19  
I wanted and let me continue on this little bit of a rant. So if you have EBIT da, right, you have, let's just, let's just take an example. You have a reported EBIT da of 1 million, we recast it, and it's not 2 million, and a synergistic EBIT DA is 3 million. Alright. And now we use, let's just say a five multiple. So your value with reported EBIT, da, so one times five is 5 million recasted. Two times five is 10 million, and synergistic. recasted EBIT, dA is 15 million. So, you can see, depending on who do whose earnings you use, will differ depending on depending on the earnings stream. All right. Alright. So, we use market data to determine how a buyer typically behaves towards an investment. But when we move into synergistic values, it it's a whole different ballgame because, as I said, Eat unless you know, who that synergistic buyer is and why they're doing it and what they're saving. You have no idea. So it is so it changes and we'll it will be difficult for us to to determine it without taking the business to market. Now. You know, most private companies want to increase the value of of their company and in, in, in not only market value, but in strategic value, they want the they fail, at times they fail to understand that the acquisition multiple is specific to that buyer. And again, I know I'm reinforcing that, but this is the big takeaway. And that risk affects their multiple because the multiple is risk. And then the return is, you know, what is the EBITA available post acquisition app. So again, I pay myself or someone to run it, I paid my debt, and I get a return of in my oven on my investment. So how, you know, that drives my value? And how am I going to be able to grow the business? Or? Or do I choose not to, but that's what the buyers are looking at. So now let's look at fair market value. Right. As I said, I, I received an appraisal this this week, and somebody now was, was somewhat distraught over, over my my opinion of their fair market value appraisal. And, again, fair market value is perfect for IRS courts. But it's not. It's not so much in my world. And so, so the question becomes, will fair market value mirror the reality of the marketplace? I don't know, I don't know if we're ever going to get we're ever going to get to that place in valuation. Where, where we totally understand how how I think we can get there with a range, I'm not certain we can get there as a specific number. Now, I want to talk about transfer channels, like how do you transfer the business out of out of the ATM from your ownership to someone else. And again, a lot of this depends on size, but generally speaking, these are the, these are the ways you can transfer your ownership or Divest yourself of ownership, when you can, you can give it to you can go to the employees, you could go to charitable trusts, you can go the family, you can go to other co owners, you can go to to outsiders, right and retire, you could go to outsiders can stay with the business, or you can go to or take the company public chances are you if you're listening to this podcast, you're probably not a public company. But when we go to two employees mean worth we're often talking about Aesop's and management buyouts, when we're talking about charitable trusts, we're talking about charitable remainder trusts, donor advised funds, things like that, where the the business has, has been sold to, you know, sold into a trust and either is being used for family purposes or for charitable purposes. We go to the family could be gifts. If it goes to other owners, again, that's Buy Sell agreement. If it's to outsiders, that's my world where we sell to, to independent third parties. If we are looking at outsiders, and you continue to stay in the business, typically in private equity. Now, those are our roll ups. And then public companies or, you know, to public companies. So the question is, and this is kind of tying this op, do most owners want to create value in their company? No, they don't. And in this in a wrong answer. If they just don't they want they want to create a lifestyle. They want to create a lifestyle for themselves. But is there anything wrong with it? No, there's there's nothing wrong with it until Guess what? Until you go to sell and then we have then we have an issue because now we are in a you know we are in a bit of a challenge on how to effectively transfer that company out. And so when we're You know, typically these things happen on a tenure cycle. Alright, so we're so you and I, in our case, we're probably from a timing standpoint, it's, it's always good to so a good business will sell in any environment, I think you're going to see for the next couple of years, it's going to be somewhat volatile. But then I think there's plenty of time to capture, you know, great opportunity to, to sell so. So anyway, I do think that, that as we continue to the election years, it's kind of hit or miss, you know, chances are, our sales tend to increase, you know, when there's a Republican president just just is I don't know, I kind of have my opinions as to why but nevertheless, there is, you know, that's, that's just often the way it the way it is. So I would anticipate, you know, 24 into 25, we start to pick up pace as far as am more more people selling, and more people buying wanted the business owners that are listening to remember that they control the transfer value, right? They they ultimately decide which of those transfer channels they want to pursue. Now, certainly, I strongly suggest you talk to your accountant, you talk to, to an exit plan, or you talk to, you know, even your attorney about, you know, if they're versed in m&a and transfer channels, what is what is ideal for you? Because it may, it may differ. Because remember, you have you know, and let's just talk about, let's just revisit the devalues as they increase. So asset value is the lowest, then we move into management buyouts, which are more investment value, you have ESOP. Again, remember, what we're talking about those are government, the government fair market value determines determines what fair market value that value world, then you have, you know, equity recaps, alright. So, you know, when we have private equity groups that roll up companies in the business owner gets to keep a, a fractional interest of the company, that's a financial market value, then we move into negotiated, alright, that's more when we move, take it through our process that's owner owner value, and then we have, you know, owner value and then synergistic value. And then I told you, in this case, I know are in for my audience, chances are, it's not public that we don't have to address public value. So everybody needs to understand down the

Ed Mysogland  27:59  
debt, they need to create value in their company. And that's always been the challenge, and there's nothing wrong with it. But for those, for those of you that aren't selling in the next two to two to four, even five years, now, there's, there's excellent opportunities to to begin the process of creating value, what can you do, you can stop, you can stop being the person that drives all of the earnings, right? If you go away for a month, what happens to the company? If you have customer concentration? How do you diversify that? If you have supplier concentration? How do you do that? Do you understand the cost of acquiring a customer, these are all and this is just the very tip of the ice iceberg about the things that we that you need to understand in order to create value. So to kind of conclude this, you need to understand when it for those of you that are that are moving into this, and thinking about selling and the whole selling process is more sport and business. I mean, there's some bobbing and weaving and and those of us that that know, know the game and how it's played are in a superior position to those that don't. We have the companies that need the most help. And this is this is has been the case forever those that that need the most help or the least willing to pay for it. Probably one of my one of my partners, his name's Larry matsing. And he has always said, you know, in our world, the deal only starts once it has died. It's just that it's when our fees are justified and and and when really the rubber meets the road. You need done understand that, the more the more people that are, that are involved in, in the m&a process, those that have experienced and are ideal deal team members. So you don't want to have to educate your attorney that did your, your cousin's divorce as your m&a attorney, it just, it's going to end up badly for you. So the more you care about the deal, the less likely it's going to close. And and I say that only from the standpoint of you need to be sale ready at all times. That's just, that's just good business. Because as you know, and I guarantee that you receive letters regularly, and calls about, hey, I want to buy your business. Well, if you're always in a position to sell, yeah, you can you can feel one of those one of those questions and determine whether or not there that buyers is legitimate. And then I think the last thing is, and there's no guarantees in m&a, you may everybody may do everything right. And, and, and things things still may go bad. And the deal may not get done. We had a deal where there was some foreign capital that was going to fund a deal of ours. For our family, and an era the the stock market of that of that country crashed, and everything was done. It was just waiting on funding. And it crashed in and killed the deal. So yeah, it's never over until until the the checks get cashed. You know, I think that as long as you think about valuation, I hope that the biggest thing you took from it is that there is a there is a wide range of values, depending on who that person is that's looking at your business. So don't, don't be offended at it. It just depends who who is doing the valuing. The other thing is that the process is will determine the value by confidentially exposing your business to the marketplace, you will ultimately figure out who the buyer is what the risk is, and, and and that determines your value. You don't have to accept it. But though, you get 235 offers, at generally the same price, you've determined market. So keep that in mind. And then And then lastly, we we do we talk a lot about value and market data that we're we're seeing all the time. And if my door. We haven't been around for 40 years, you know, not sharing information. And whether we do business or not, we're more than happy to share what we have to make sure that you make a great decision. So that's it for this week. I hope you enjoyed this rant about about values and the how value is is viewed depending on the virus, and then I'll see you next week. Thanks so much. This was another episode of the defenders of business value podcasts are more episodes packed with strategies to increase the value of your business visit defenders of business value.com For shownotes transcripts and free tools to start you on your journey. Subscribe now so you don't miss any future episodes.