I work a lot in the business of mergers and acquisitions, and it leads me to want to talk about a one-off topic here. When I evaluate a business for what I think it is worth, I start with a basic formula:
Value = Multiple * Cash Flow + Net Assets
I use Cash Flow instead of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) because I work with several industries that have a significant number of fixed assets and invest in these assets regularly. There are two points of debate when we talk about this formula. First is what is the Multiple. Second, is what are the net assets. The Multiple is always a discussion and for most small businesses they number runs between 2 and 5. Net Assets are a discussion because there are multiple ways of valuing the asset.
In the past, I posted a series on Inorganic Growth. Inorganic Growth is the purchasing of other firms to help accelerate your growth. The alternative is Organic Growth which is all about growing the existing business. The goal of both is to expand the Cash Flow but come with some risks. A well-cited statistic is that 75% of all acquisitions "fail". I think this number is understated as success should be about generating more Cash Flow than the purchase price of the firm. Organic Growth often requires investment before profit expansion. A typical method would be to hire additional Sales Staff. This Sales Person (or People) need to get paid before they bring in new customers. Depending on your typical Sales Cycle, this can be a long time.
A lower risk alternative is to look at the Asset side of the equation. The most obvious thing to do to grow Assets is to acquire the building that your business is located in. For a large business, this is not generally a great idea. Their investors want them to invest their capital in their primary market. For a small business, the investors might be just the owner. By buying a building, the owner is diversifying his or her business investment. It provides a potential for additional value at the sale - though not at a Multiple. The owner may also decide to keep the building and keep the cash flow from leasing the space. Finally, there is a tax advantage in the deduction of the Depreciation from paying off the building.
So, I hope that helps Owners think about how to expand the value of their business. Have a great day!
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