Having a good understanding of what is included in the valuation of your company may help you to better understand what you need to focus on when preparing your business for sale, whether you intend to do that now or in 25 years’ time. The timing of the sale and even the appraisal of your business could affect its value. It’s important to know about the inside and outside factors that can negatively impact your business’ value so that you can take the right steps to build it back up. Join us for an informative conversation with Mr. Randy Lewis, CFA and Managing Director at LP Valuation in Los Angeles.
Choosing which companies to use and looking at good comparable companies and adjusting those multiples up or down depending on the subject business that we’re valuing, that’s the art.
- Randy D. Lewis
Jeff: Welcome to Deal Talk, brought to you by Morgan & Westfield. I’m Jeff Allen. If you’re selling or buying a business or just interested in the subject, this is the place to be. Our mission is to educate and inform you with the help of some of the most credible, highly-regarded experts in the industry of transacting businesses so you’ll be better equipped to make some very important decisions when the time comes to sell your business or to buy one for that matter.
Today on Deal Talk, we’re going to talk about the importance of simplicity when it comes to selling your business, beginning with the appraisal process. And to do all that, we’re joined once again by one of the best of the best. And his name is Mr. Randy Lewis. He is a Chartered Financial Analyst and Managing Director at the business and valuation consulting firm, LP Valuation, LLC in Los Angeles. We’re going to talk to him a little bit about how to keep things simple, and some of the key subjects and topics and issues that come up that he’s had to deal with that you need to be mindful of when it comes to having your business appraised.
One thing that I’d like to say about Randy, some of the businesses that he deals with, Internet and tech companies, including software-as-a-service and mobile app businesses, as well as professional service companies including healthcare practices, physicians and attorneys among other specialties. So there are very few business types that he hasn’t really dealt with. But this is a gentleman that we’re looking forward to speaking with right now. And, Randy, I want to thank you so much for taking time out of your schedule to join us today on Deal Talk.
Randy: No problem, Jeff.
Jeff: Let’s start by asking a question having to do with revenue and earnings. And the question that comes up, and we’ve heard it asked many times here amongst people who have come to the interview page at Morgan & Westfield website, they’re asking, “Do revenues or earnings have a greater impact on the value of my business?”
Randy: Well, it really depends on the business that we’re talking about, number one. And it also depends on the stage of maturity or development that the company is in as well. If you look back to the mid-90s with the Internet, it was all about building revenue. Everyone knew that the pie was huge on the Internet; they didn’t know how huge. The business models were undefined at that time. So the logic at that point was: get as much market share as you possibly can and then everything else will work out, right?
I think it really depends upon the business. Now, we deal with a lot of small to medium-sized businesses in our practice. And typically, the café or coffee shop on the street or small restaurant, or something like that, they’re really capped – I always use the term “finite” – there’s a finite amount of revenue, really, that they’re going to get. Unless there’s a line down the street which rarely there is with a restaurant, they’re going to be capped at revenue. If that’s the case, then earnings would matter much more than revenue. If it’s a model that’s scalable or can be built upon, then revenue would matter more or as much as earnings, so it really depends.
If you look back to the mid-90s with the Internet, it was all about building revenue. So the logic at that point was: get as much market share as you possibly can and then everything else will work out.
Jeff: What about those people who come to you and say, “What should I do? Should I work on, should I focus on building my revenue up?” And maybe they’ve got like a year that they’re looking at ahead of time to sell their business, or they could very well be down the road in terms of the appraisal process. What do you tell them when they ask you a question like that?
Randy: It really is case dependent. I think that just going back to my restaurant or sandwich shop, or whatever you want to look at, I think that a lot of businesses get to the point where the only revenue growth can really come from opening more locations. So if that’s the case, that’s really a strategic decision that they have to make. To a medium-sized business, that’s doing $10 million to $20 million in revenue; I think possibly more revenue growth might be part of the model. I don’t think you should ever not focus on earnings. In today’s environment, earnings should always be a concern. However, at some point, you need to think, “Is scaling an option? Is scaling going to get me more value or more compensation in the long run if I do decide to sell my company?” Those are things that you have to consider.
Jeff: That said, there are a number of other very important factors that go into the idea about what exactly contributes to a reduction in the value of a business. Can you talk about what you believe might be the two or three most important factors that reduce the value of a business, Randy?
Randy: I think number one is if the margins aren’t there for whatever reason. If your business is 10 years old and your earnings aren’t there, or your gross profit is too low, or some of the margins that buyers would normally look at; there’s one of two things wrong - either you’ve been mismanaging the company and I can turn it around if I’m a buyer (in that case I might be very interested in your company) or it’s just not there and there’s not a lot you can do about it. And if it’s not there, that leads to problem number two, which could be a declining market; either the market is declining in general, or your business is just not able to capture market share, maybe because of location, or general geography or something like that. So if that’s the case, you probably should either shut the doors or consider selling at a discount.
Jeff: Randy, I know that your business is you work with companies as a business consultant, so I would imagine that a number of people come to you for advice and guidance on things that can help to turn their business around. We just talked about the two or three factors that lead to a reduction in the value of a business. Is there anything that you can think of that you run into time and time again, with the people who come to you asking for your company’s help, that you turn around and say, “You know what, this isn’t rocket science here. If you could only do this, this would really turn things around for you, or you could start to see a turnaround.” Is there a factor or two, that is common among many businesses that you consult with, that really are easily correctible, that companies don’t have to necessarily spend a lot of money? I didn’t necessarily say time here, but that companies can easily take and turn around or rectify in order to increase the value of your business? And maybe you’ve actually seen it done.
Randy: Are you talking about when the business is listed, or for sale, or just in general?
Jeff: I’m talking about in general, because obviously if someone is doing something right now, or not doing something right that is causing a reduction in the value of their company prior to selling it, and they knew that there was a way to correct it, maybe they have no inclination towards selling it. They just want to do what’s right. They want to increase the value of their business for later. What is it that you’ve seen that may be causing people a lot of angst in seeing those numbers fall in the value of their companies that are things that are actually pretty easily correctible?
Randy: I think that it’s also case dependent and would take some analysis. You’d be surprised how little analysis is done. Sometimes the accounting isn’t even proper accounting for companies that are doing $10 million to $50 million in revenue. These aren’t small companies, and they’re just really run like mom-and-pop’s.
If your business is 10 years old and your earnings aren’t there, or your gross profit is too low, or some of the margins that buyers would normally look at; there’s one of two things wrong - either you’ve been mismanaging the company and I can turn it around if I’m a buyer or it’s just not there and there’s not a lot you can do about it.
Jeff: Does that surprise you when you have people come in and you look at their books and you’re thinking, who’s doing this?
Randy: Not anymore. It’s Silicon, and usually when we do an appraisal before I price an appraisal and give the client an estimate, I look at their QuickBooks file. Because if I have to go through and fix everything before I even do an evaluation, you’re going to have to pay in for that. So better to pay a bookkeeper than me. But you’d be pretty surprised – and I’m not anymore just because I’ve been around, I was in the beginning – how these companies operate and how little analysis is done. And that really comes from – and if you’re going to point to one thing, it’s the owners wearing too many hats, and they know the business. They’re successful entrepreneurs; I have a lot of respect for them, but when it comes to number crunching or analyzing those numbers, either they don’t care or they don’t know how to do it.
Jeff: And they just assume that everything is working out and there’s no real attention – they’re worried about the operation of their business and not so much about the numbers. Well, you’re listening to Deal Talk, by the way. And my name is Jeff Allen. With me on the other end of the phone line there, that gentleman you just heard, Mr. Randy Lewis, is Chartered Financial Analyst and Managing Director at the business and valuation consulting firm, LP Valuation, LLC. Something I’ve always wanted to know, Randy, can I get paid for the potential of my company?
Randy: Not from a smart buyer. Typically, what happens is you can go on any website, you can even go on Craigslist if you want to, or BizBuySell, or any of those websites, even the Morgan & Westfield site if they have listings. They essentially have the same logic which is if you do XY&Z after you buy my company, then you can make something out of this, or you can increase – it’s got so much potential. I usually just stop reading when I read that. And if I’m a seller – or I’m advising a seller, I should say – the first thing I always say is “If it’s easy as you make it sound, why don’t you just do it and then sell your business and capture that value instead of selling it at what’s going to end up being a discount and having a buyer capture that value?’
Jeff: Now, when you ask them that question, are you met with stunned silence or just the sound of crickets in the background?
Randy: Well, yeah, usually. And that tells me – well, actually that could be a lot of different things. One is they know it’s not as easy as it sounds, and they’re just trying to institute some salesmanship - but I’m not saying that’s wrong necessarily – or they’re burned out. They’ve waited too long to sell the business. They haven’t prepared to sell the business. They wake up one day and say, “I just can’t stand this anymore.” And then, they’re stuck with the current status of the business. Instead of preparing years in advance, which they should have been doing, it doesn’t take a lot of work.
I think people overestimate what’s involved in preparing a business for sale. When you say that phrase “prepare my business for sale,” it’s open-ended, right? And a lot of people can’t get their mind around it and it just sounds like so much, and it’s really not. It’s cleaning up the books. It’s preparing the financial statements and proper accounting. It’s making sure your banking relationships are good, your debts are paid, and you don’t owe anybody any money outstanding that’s not in the normal course of business, simple things like that.
They [business owners] are successful entrepreneurs; I have a lot of respect for them, but when it comes to number crunching or analyzing those numbers, either they don’t care or they don’t know how to do it.
Jeff: One would imagine that you could probably simplify it by equating it to taking care of your checkbooks, and, just like you would at home, making sure that your check book balances. if you know how to do that, and of course, so many people don’t have to do that anymore because it can go right online and they can see the bank is keeping a running total debt. And sometimes, the bank gets it wrong. But let’s put it this way; while it is simple, there is a little bit more work involved and sometimes it just seems to me, I’m just thinking off the top of my head, that, that work is somewhat intimidating.
When people think that it could take them X amount of time, that’s time away from their watching the operation of their business and then creating sales. But really, at the end of the day, it’s just as important a function in the operation of your business as it is going out and generating the sales and continuing to improve the quality of your product. So what you say makes perfect sense, at least certainly to us during the scope of the program in this discussion. Let’s talk about approaches to settling on a value, or setting a value on a business. Earnings multiples: is it a good approach to setting a value on my business or not?
Randy: Of the three approaches that we use, it’s probably the most common because it’s actual sales. So there’s databases that have tens of thousands of transactions and depending on the business, easy to find those multiples. They’re fairly accurate assuming the data that was inputted into the database is accurate, which we have to trust something, so it seems reasonable. And we can take an average and we can narrow it down by location, by typically sales is how we narrow it down, so if the business is doing $2 million in revenue, we’ll look for sales between $1.5 million and $2.5 million in revenue or something like that, so we can capture some transactions on each side of that $2 million. So we have a list of 30 businesses that have actually sold within the last five years or so. That’s a pretty decent gauge of what the “market” has been paying for similar businesses. I think it does have a lot of merit.
Jeff: Does the approach that you use just really depend on the type of business that you’re valuing at the time?
Randy: Yes, it does.
Jeff: And for those that are tuning in and may not be necessarily familiar, Randy, and they haven’t even thought about putting their business up for sale; they’re not necessarily interested in it at the immediate moment, the other types of approaches or methods that you use are what?
Randy: Well, sometimes we use an asset approach, and that would be for capital-intensive businesses that have a lot of assets in there.
Jeff: Machinery, manufacturing company perhaps?
Randy: Yeah, probably. I think the equipment manufacturing is exactly right, sometimes real estate even, if the real estate’s included and priced. That would be a valid option. Now, with Internet companies, SaaS companies, companies like that, there really has no bearing the traditional model. The other approach, the third approach is an income approach, where essentially investment theory 101 states that the current value of an investment which is what the business is, the current value of any investment is the present value of its future cash flows. So I look at what I’ll be able to take out of the business that’s necessarily in the form of cash or earnings, and what are those future benefits worth to me today.
So, I pick a discount rate and I discount this back to today’s value. Theoretically, that is a 100% sound approach to valuation. In theory, there’s a lot of subjectivity because you have to forecast, number one, and then forecast the future benefit stream. And the discount rate is somewhat subject, so we use different methods on coming up with that discount rate. But there could be a lot of leeway there. So you’d have to take that into consideration as well.
If you do your job right, the market approach that we talked about with the multiples and the discounted cash flow approach over income approach should be relatively similar.
Jeff: Randy Lewis, Managing Director and CFA at LP Valuation in Los Angeles is our guest today on Deal Talk, brought to you by Morgan & Westfield. My name is Jeff Allen, thank you again for joining us. Hypothetical here, Randy, I’m preparing to sell my business within the next year. Can the timing of when I get evaluation through your firm affect the value of my business?
Randy: Theoretically, yes. In reality, it’s probably not going to be that much different unless there’s a drastic economic event, like we have the Great Recession. Company values between 2007 and 2008 were dramatically different and multiples fell. And then, it took us three years or so to come out of that. But I think the economy has been better. People are still cautious. Value investors are still out there, nobody wants to overpay for anything. So again, it’s going to depend on the business. But I don’t think timing necessarily is going to make a huge difference.
I will say one caveat, however, with these high-tech companies, particularly with mobile apps and SaaS companies and things like that. The technology is changing so much and the options, essentially meaning the competition is growing so fast, that if that’s the case and you’re looking to sell something in those markets, timing could make a big difference because somebody could come out with a better app than you have in three months. So you always have to be careful in that respect. But if you’re the coffee shop on the street, I doubt it’s going to make that much difference in timing.
Jeff: You work, I know, with a lot of tech companies. And when you’re talking about tech companies, you’re talking about companies with a lot of intellectual property, rights patents, trade secrets, things of that nature. You can also put manufacturers into that category as well. Do these need to be valued separately from my business when it comes to time for appraisal and valuation?
Randy: Well, only if there’s a financial reporting. The short answer is if the IRS and SEC’s say so, then yes, otherwise, no. But then I think that if we tend to look particularly at smaller businesses, the brand value, the trademarks, the copyrights, the patents are reflected in the cash flows. There’s a solid argument that says that intellectual property is only as valuable as the cash flows that is generated. So I think that we don’t do a lot of separate valuations. We have done them specifically for tax reasons. But I think mom-and-pop on the street, medium-to-smaller businesses, I wouldn’t think that it would be necessary all that often.
There’s a solid argument that says that intellectual property is only as valuable as the cash flows that is generated.
Jeff: Randy, sometimes when we want to keep things, or we know we have to keep things simple, or make them simple, it requires us to do some planning which is sometimes not something that we really want to do, we’re uncomfortable with it. How far and advanced - however, when we’re talking about selling our companies – how far and advanced should we really start planning the process of doing that, even when maybe the sale of our company is not necessarily imminent, it’s not close-up? How far and advanced should we really start the planning process?
Randy: Well, I think three to five years is about a safe bet. I think that the planning can get more intense as the time to sell becomes closer and more imminent. I think it’s good to start planning well in advance. What planning does, is it provides a road map. It provides direction and it makes things, if you do it right, simpler than what they seem. It’s breaking down that open-ended statement of I’m going to sell my business. I need to start preparing or planning and turn that open-ended statement into a series of steps that are much more manageable. So I think that’s one of the huge advantages.
That takes me back to the earlier question about preparing the business for sale. One thing you can do in your one of five, and you can just leave it at that, is “Are my books being kept properly?” And all you have to do is have someone look at them. So you pay a CPA or you pay someone like me or a consultant, to look at the books and say, “Yes or no?” All you’re looking for is “Yes or no, this is proper accounting.” Everything’s being accounted for correctly. And your bookkeeper is doing their job. If that’s the case, year one is done.
Jeff: There you go. And that way, you help to pave the way for keeping the next two, three, four – the next four years, solid as far as your bookkeeping goes. And anyone who knows, and I can speak from experience. You go back and you look at your own books, if you can’t make heads or tails out of what you’ve done, there’s a problem. And imagine looking at ten years’ worth of that. My goodness, just the trouble that could ensue. So, really, we hear you completely, Randy.
The point is here, if you’re just thinking about the books by themselves, you already know the importance of planning ahead and being careful to use the proper accounting procedures and having someone do that stuff. If you don’t want to do it yourself, I think your point is really make sure you can afford someone who can take care of that for you.
Randy: Of course. And you don’t have to pay them to do the accounting. All you have to do is pay them to make sure it’s being done correctly.
Jeff: There you go. So, that said, CPA, I’ve got a certified public accountant, how heavily involved should they be, Randy, in the process of having my business appraised? And do you work with them or have you seen this happen often?
Randy: Yeah, it depends on the relationship. I’ve seen just like any other professional service, there’s people that I see, and I think aren’t doing a great job or aren’t spending enough time with their client, and I’ve seen great CPAs. There’s CPAs that are great at valuation. However, most of the CPAs that we’ve worked with are typically more accounting and tax folks, rather than valuators, and most of them are the first ones to admit that the people that specialize in valuation are probably closer to it and do a better job than they do. Usually, a CPA through us is a source of information. They can give us the tax returns. They can give us the QuickBooks. They can give us answer to questions. And they’re basically just, again, information sources for us.
I would urge business owners to just make sure that, again, their accounting is being done properly. I would have someone other than their CPA for their taxes look at their accounting to make sure. Often, tax folks get bogged – taxes, they do well at the same time, right? So you’re automatically getting them at their busiest time of year. I’ve seen CPAs, they really haven’t checked the accounting at all. They’re relying on what the business owner gives them, which covers them from a liability perspective. And if you give me your financial statements, I’ll file your taxes. So nobody’s checking to see if those financial statements are correct, however.
I would urge business owners to just make sure that, again, their accounting is being done properly. I would have someone other than their CPA for their taxes look at their accounting to make sure.
Jeff: So again, don’t fail to plan in that regard. We have just a few minutes left, no more than about three minutes left here, Randy. Real quick, the transaction database, as we’ve all seen. We’ve heard about them and I’ve asked others about them before. How useful are they and should I rely on them for helping me to establish at least a rudimentary value for my company?
Randy: I think it’s a good way to establish a rudimentary value. I think that when we take evaluation engagement, we look at all three approaches that I mentioned before. One of them being looking at the transactions and the multiples. And what we say in the business is that valuation is art and science, right? Taking the multiples from a database is science, right? Choosing which companies to use and looking at good comparable companies and adjusting those multiples up or down, depending on the subject business that we’re valuing, that’s the art.
I think that we’re given sources of information, both from a financial perspective in the market, to discount rates and so forth. We’re getting transactional data and we’re getting data from the company. So taking those data points and putting them on a spreadsheet is science, and really looking at the company in its entirety, and looking at the three different approaches and using our experience based on other similar businesses that we valued, and coming up with a reasonable basis, that’s the art. So I think that transaction databases are great. We use them all the time, but in the context of the whole pie, in the context of the whole picture.
Jeff: Takeaway time, Randy. You’re on your elevator down from the office. You’re wrapping up your day. You’re going down to the garage. Do you have any other takeaways, quick tips, items of advice you could pass along to that guy riding in the car with you about valuing his business, selling or appraising his business?
Randy: Well, I think making sure the financial statements [are correct], I can’t emphasize that enough. We used everything that we use. We did some work with a yogurt franchise here in Southern California, extremely successful. They hired the company to come in once a year. They paid them pretty well, so not every company’s got to work within their budget. But once a year, they had someone from the outside who is not emotionally attached to the business come in and assess where they were. And not everybody has to use that exact method. But I think it needs to be done. So you need to work with professionals that can make sure that you’re on the right track, make sure that the accounting is in order. Those businesses get more value in the long run, and your price goes up when you sell it.
I think that the planning can get more intense as the time to sell becomes closer and more imminent. I think it’s good to start planning well in advance.
Jeff: Randy, as we sew things up today, if people want to reach out to you and they have some questions that they’d like to get your feedback on, or your input, where can they reach you? How do they get in touch with you?
Randy: Sure. Thanks, Jeff. They can reach us at 818-783-5006. That’s 818-783-5006 or visit our website at www.lpvals.com.
Jeff: Randy Lewis, thank you so much for joining us on Deal Talk.
Randy: Alright. No problem, Jeff. Thank you for having me.
Jeff: That’s Randy Lewis. He’s Chartered Financial Analyst and Managing Director at LP Valuation, LLC in Los Angeles.
And you’ve been listening to Deal Talk presented by Morgan & Westfield, a nationwide leader in business sales and appraisals. If you’d like more information about buying or selling a business, call Morgan & Westfield at 888-693-7834, or visit morganandwestfield.com. Until next time, I’m Jeff Allen. We’ll see you again.