Gray Matter Musings

Week 5 is live!

The opportunity has been identified, you’ve surrounded yourself with a great team, and you have begun vetting the financials of your acquisition target. Now it’s time to start thinking about the numbers surrounding the business, which begins with remembering that you are “buying for the future, but paying for the past” (Deibel, 2022a). Thus, before anything moves further, you must understand what the business can afford to be bought for and that “the business can afford to pay for the business” (Deibel, 2022a).

Indeed, this sounds like a daunting task, diving into complex financial numbers. Rest assured, this takes place every day and with some prep work, is just another step in the process. First, use the resources and team around you when necessary, such as understanding how the business runs its accounting. Accrual vs cash basis accounting is a key factor, as it helps highlight how cash moves through the company. While accrual based accounting provides more insight into month to month performance, cash based accounting often leads to a reduced tax bill.

Next, you must decipher if the company is in a healthy position, after all, they are selling for a reason. In this regard, the author suggests five (5) areas for deeper investigation: “revenue, profit, operational efficiency, cash flow, and the total owner benefit (or SDE/ Seller Discretionary Earnings)” (Deibel, 2022a). Nearly all of this information will be found in the pro forma financials we have already examined in this course, which is the balance sheet, income statement, and statement of cash flows. You already have a leg up on the competition here by working through your financials spreadsheet! However, other things within the numbers that you will want to examine include assets, which may be short or long term. Are these assets tangible (land, building, equipment) or are they intangible, such as software. This shines a light on the need to investigate any intellectual property affiliated with the business. Is there existing goodwill (another intangible asset) that can boost the value of the business? Goodwill can include things such as a customer list or lead pipeline that can stand to generate earnings for the company. Finally and perhaps most importantly, what does the owner’s equity look like (this is synonymous with SDE)? This helps you discern the earnings that have been placed back into the business, as well as how much the current owner can afford to pay themselves.

Now, as we wrap up week 5, the author highlights the “critical factor”, which is you, the entrepreneur (Deibel, 2022a)! When analyzing past performance, it is critically important to understand this all took place under previous ownership and begin thinking about bringing your skillset and CEO mindset to the table. What can you keep, what can you change, how will you grow? Remember, the secret sauce is you! Finally, this week also dives into valuation of the business itself. The two most common ways of valuing a business are “asset based and cash-flow based” (Deibel, 2022a). The three (3) primary asset valuations include book value (BV), fair market value (FMV), and liquidation value (LV). Alternatively, cash-flow valuation includes two (2) common methods, which are discounted cash-flow (DCF) and valuation multiple.

Within the asset-based valuation, book value focused on valuing the company based on the balance sheet or the “net worth of the company as reported by its financial statements” (Deibel, 2022a). This can prove challenging as assets are only beneficial provided they can generate revenue for the business. Fair market value addresses the challenge of assets being overvalued. Thus, assets are uniquely valued based on condition, which can be helpful if purchasing an asset heavy business. Liquidation simply estimates the value of an organization’s assets under a “fire sale” scenario, where everything must go (also subtracting any liabilities).

Alternatively, cash-flow based valuation is often preferred by entrepreneurs as cash flow is what you are most interested in! Discounted cash flow uses past performance and projections (with many assumptions) to dial in on future earnings. The goal is to arrive at a discounted current value by applying a weighted average cost of capital. Sounds complex, right? Well, entrepreneurs aren’t dummies and from this madness, the valuation multiple method was born! EBITDA and SDE “represent the cash flow of a company over prior years to shareholders/owners” and this figure proves crucial in the valuation multiple method. While markets can shift, most small business will sell for “2-3 x SDE”, while “middle market companies under $5M in transaction value will sell for 2.5 – 6” (Deibel, 2022a). This means simplicity, as from the financial statements you’ve received, you can immediately begin running some fuzzy math by finding the SDE/EBITDA/Adjusted EBITDA and running multiples on those figures to reach a feasible purchase price! From there, it’s up to you as this isn’t a single answer problem. You must calculate what the business is actually worth to you!

I hope each of you enjoyed this book review and accompanying reflections! Worth noting, I will continue to post reviews on a weekly basis regarding “Buy Then Build”, for those who are interested in continuing the journey!


References:

Deibel, W. (2022a). Buy then build: How Acquisition Entrepreneurs Outsmart the Startup Game.