Establishing a valuation for your company is a crucial process. You’ll need a valuation for the following purposes (and these are just several): sale of the business to a third party; taking your private company public; merging with another company or acquiring another company; for a buy-sell agreement; for the issuance of such incentives as stock purchase options… your company’s valuation is important. What is equally important is that the valuation is properly documented, the computation strongly justified and supported, the actual process is undertaken and overseen by an impartial, objective third party with the appropriate credentials. Valuation of a company is a target which moves and changes over time depending upon the company’s performance and other variables, so periodic valuations of your company are important to stakeholders, creditors and potential investors or acquirors.
If the business is passive, and merely serves as an ownership vessel for income-producing property, equipment, securities or the like, establishing a valuation can be relatively easy. Simply take the combined Fair Market Values of all of the assets, reduce this amount by the total liabilities on the books (and perhaps some contingent liabilities in certain cases), and you have a basic valuation.
If the business is an operating entity (usually in the form of a partnership, an LLC or an IRC SubChapter S corporation), and income from operations is generally being swept out to the maximum extent possible to the stakeholders who work for the entity, the valuation issue is somewhat more complex. The business’ books might reflect very little in the way of appraisable assets, making a Fair Market Value approach untenable. The business’ true value is in its Human Capital, which is unreflected (lamentably) on its books.
Most of these operating entities must be valued on a more subjective, judgmental basis, which usually involves some capitalization or discounting approach based upon the entity’s distributable income prior to any distributions made to the owner-managers.
Several prospective methods (all variations on the Net Present Value theme) are offered for your consideration, with the caveat that these methods assume [and we all know what happens when we assume] that the business being subjected to the valuation has been in operation for a period of no less than five consecutive years:
1) Simply add the most recent 5 consecutive years’ distributable income together to arrive at a value;
2) Average the most recent 3 consecutive years’ distributable income and multiply that result by five;
3) If the business has shown a pattern of consistent growth, you may consider using a weighted average method, where, for example, you’d take (say) 50% of the most recent year’s distributable income, 30% of the prior year’s income plus 20% of the earliest of the three years’ respective distributable incomes, take that weighted sum and multiply it by 3 , 4, or 5.
My inclination is to utilize the third approach because it gives effect to growth and affords the most recent income-generating period the highest weight.
Venture Investors have been investing more speculatively than necessary — not based upon their selected investee companies or projects — but in terms of their “all or nothing” deal structure, which usually is based upon the occurrence of an event (such as an acquisition, going public or some other exit) which provides capital recovery as well as gain, if any. While waiting for this event, the investor either doesn’t receive cash flow at all, or receives some debt service payments if the deal was structured as a loan of some sort, plus equity. Most important to note is that most investors are not truly looking at the investee’s fundamentals and inherent profitability as a free-standing entity. This not only affects the deals selected (i.e., flash versus fundamentals), but it puts the investor into an uncertain period of little or no income and limited liquidity.
I am proposing a less speculative and more liquid deal structure based upon the use of Revenue-Based Royalties as capital recovery devices (to reduce risk over time) and as a means of generating a stream of positive cash flow to the investor. And this cash flow, if sufficient, can be re-invested to maximize total portfolio return.
The method is simple. Regardless whatever the other particular details of the deal structure, add a net revenue-based royalty (as set forth in the illustration below). This approach can also have the effect of making many a less-than-glamorous early-stage enterprise look considerably more attractive. I believe it would make more money available to small businesses and middle-sized enterprises that are less than revolutionary in measuring their intellectual property or market capitalization potential.
This approach is much “cleaner” than profit-sharing in that it does not permit subjectivity or manipulation of the numbers. It’s simply elegant: The investor takes a look at the investee’s bank statement, multiplies the non-investment, non-loan, cleared deposits (ostensibly the proceeds from sales activity), multiplies that number by the applicable royalty percentage expressed as a decimal, and is paid appropriately.
A temporary cash crunch situation is something that occurs in the ordinary course of business in most every organization, especially when the business is of a seasonal nature or when the businesses is in a rapid stage of growth, i.e., inundated with purchase orders but without sufficient cash to fill them and to also pay recurring expenses. But if a cash crunch situation is chronic, a diagnosis of the reason must be made, and appropriate actions must be taken. This article will give you the ability to do both.
Bear in mind that when I speak of revenues, I mean total sales, both as computed on the cash basis and the accrual basis, but when I speak of expenses, I actually mean cash outflows of every nature. Throw away the accounting and auditing textbooks for just a bit so that we can deal with bare bones economic reality. Also by current, I mean as either generated or paid in the ordinary course of operations.
Most every enterprise experiences a period or periods of cash crunch, especially if those businesses are either seasonal or rapidly-growing companies which are generating purchase orders, but do not have adequate cash to fill them while still meeting their obligations, such as payroll, occupancy and the like. There are remedies for both of these situations because they are either predictable or can be financed with short-term debt to enable them to either withstand the “tight season” or to let their cash flow catch up with their market demand.
If cash crunch is chronic, and is an ongoing problem, there is something wrong with the business on a fundamental level. Either revenues are too low, or current expenses (outflows — remember that we’re using lose terminology here) are too high.
If the expenses or outflows are not truly for operations but payable to a lender in the form of , for example, a short-term self-amortizing debt where the payments are large and swollen with principal, the lender may be negotiated with to arrive at an interest-only loan with a provision for a rollover of the principal at the end of its term (optimal for maximizing utilizable cash flow), or possibly a longer amortization period where the payments are lower, conserving more cash flow for operations.
Sometimes a business is improperly capitalized and it requires equity to be infused in order to retire debt. Many businesses which have good fundamentals need to de-leverage themselves by retiring existing debt with equity. This is appropriate unless the equity is used to cover current expenses.
The test is this: If you deduct the debt payments from the total current outflows, and you subtract the number obtained thereby from the revenues, the resulting number should be positive. This means that the business is not properly capitalized, but is probably fundamentally sound. These companies are good candidates for refinancing.
If the number obtained is still negative, then it is highly likely that the business is fundamentally unsound, either due to its core purpose, mismanagement or some improper assumptions which have gone uncorrected for too long. Revenues can be increased by increasing sales through better marketing and sales, or by increasing prices if the market will tolerate this.
When certain food or beverage prices are suddenly increased, a restaurant may hike up its prices and say, for example that “due to the increase in the cost to us of coffee, we are sorry to have to raise the price per cup to $2.25. If the market tolerates this it is a wonderful strategy, especially if done in steps, or if accompanied by a re-packaging or the product or service to somehow differentiate it from what it was previously. The perception of added-value tends to justify an increase in price.
The other possibility is more difficult, and the prospects less pleasant: You may have to negotiate with your employees (or terminate some of their positions), cut back on the use of your contractors, or re-negotiate costs with your vendors. Vendors can often be persuaded to reduce their charges by 1) indicating that the situation is temporary, and that they’ll receive a premium after you’ve reached a certain sales level or after a certain amount of time has passed or 2) an incentive wherein the vendor participates in either your revenue when you’ve reached a certain threshold, or in you company’s ownership (this is an example of a partial vertical integration strategy).
The acid test of the fundamental soundness of any simple business model is this: If debt service is eliminated, do revenues exceed current expenses. Put more realistically, without considering debt, do your revenues (where the earnings process is complete and they are either in the form of cash or accounts receivable) consistently exceed your ordinary current operating outflows including product (inventory purchases as required) or service purchases? If not, can they be restructured to fit the aforementioned parameters? If the answer to both questions is “no,” your business model is fatally flawed, and that must be dealt with — we’ll discuss this at another time.
If you increased your sales volume, increased your prices to customers, eliminated any idle personnel, negotiated with your suppliers, and gotten your bank loan replaced with equity, then you still may be suffering because your customers are not paying you on a timely basis, while you’re paying your vendors promptly.
If your average days to payment on your accounts receivable is 55, and your average days to payment of your current expenses is 35, that 20-day discrepancy can be killing your business, depending upon your profit margins. Sadly, you can’t pay your vendors with your receivables. There are two things to be done to eliminate that 20-day discrepancy:
1) Collect the receivables faster; and
2) Pay your vendors more slowly.
That gap between average days that your business waits to collect its receivables, and the average days its takes to pay its vendors must be reduced to zero, or to a negative number.
You can collect your receivables faster by offering some of your less creditworthy customers less credit, and giving some of your better, faster-paying customers more credit. You can offer early payment incentives or cash payment discounts. You can collect partial payments in cash. Use some imagination. Any of these approaches alone or in combination will cut that 55 days significantly if you focus on achieving this.
You might even get a line of credit up to some percentage of your “acceptable” accounts receivable, factor your receivables, or utilize single invoice financing in order to get that number down a great deal further. Often the real cost of factoring or similar arrangements is about equal to what you might sacrifice if all of your customers took advantage of a discount for paying in less than 30 days.
To eliminate turning a simple article into a doctoral dissertation, suffice it to say that slowing down payments to your vendors requires some diplomacy, some negotiation, and some creativity — but then, if you are in business in these times, you must have an abundance of creativity.
Quick, Easy Metrics:
1) Your average collection days on your receivables (it’s a weighted average) should equal or exceed your average payment days on your current bills;
2) Your average collections days on your receivables divided by your average payment days on your current bills should be equal to or (hopefully) greater than 1.0;
3) The value of all of your cash and all of your receivables divided by the amount of your current bills should always be significantly greater than 1.0 (i.e., no contribution margin). While this is not a measure of cash availability, it is a measure of your gross profit on sales. The bigger the dividend produced by this computation, the greater your basic profit margin and the greater the contribution of your sales to ultimately cover fixed overhead.
The idea is to avoid a cash crunch (assuming that your basic business concept is fundamentally sound) by collecting and hoarding as much cash as you can, and holding off on the payment of bills as long as you can. Remember: If you business is sound, a cash crunch crisis is a phenomenon only created by bad timing. And it’s quite curable.