In my previous column, "Adding New Owners: Planning for Internal Succession" (February 2008) I outlined some key concepts to consider in planning for the admission of a new owner into your firm. We considered:
1. What is the goal of sharing equity?
2. What does it mean to be an "owner"?
3. What does someone have to do to qualify?
4. Is the firm ready?
Now let's drill down into the execution of admitting a new internal owner and consider:
5. What is the ownership interest worth?
6. What is the appropriate financial structure for ownership transition?
7. What should the terms of the ownership agreement be?
A Fair Price
First, the bad news: An internal transaction is typically not the best way to maximize the price received for an advisory firm. It may be the best way to maximize success and may best meet the seller's objectives, but when it comes to pure dollars, if getting the highest possible price is your objective, then internal transition is probably not your optimal choice. Because external buyers-usually strategic and financial buyers-are usually buying a majority interest, are buying for different reasons and have deeper financial resources, the prices they pay typically appear higher.
"Why would I sell for a lower price internally than I could sell for externally?" many advisors ask. There are a number of reasons. To begin with, many advisors recognize the long-term value of retaining the right people and recognize they may need to make some of those individuals owners to continue growing the business (and perhaps sell at even higher multiples in the future). Others recognize that an internal transition is the best way to meet their personal and business objectives-whether those include continuity for clients or staff, or the ability to define their timing and ongoing role in the business as they choose to.
Also, while it often appears that the "best price" is an external transaction, that isn't always true when the deal plays out. Internal transactions can be easier on the client base, resulting in lower attrition and ultimately a higher realization compared with an external deal. While the external transaction often appears to have a higher value and sounds good at first, these values frequently fail to materialize when earn-out provisions are not met.
In many of the articles written that reference valuation, you have been warned against using market multiples to value your business. I will strongly reiterate that here. While multiples can be a helpful smell test, when considering X Revenue or X EBITDA formulas, remember:
Multiples disregard the unique economic and structural issues of a business that drive value.
External buyers (e.g., banks and trust companies) tend to be strategic buyers and therefore pay a premium-the premium is built into the market multiple but should not be included in your transaction.
External buyers tend to buy control-minority interest valuations have a discount for lack of control.
There is a lack-of-liquidity discount for private company stock.
Revenue multiples are commonly quoted because they are more likely to be disclosed and they are easy to reference. However, acquirers who are focused on transferable earnings don't use them. They ignore payments made over time and the time value of money. They do not reflect the financing structure and who bears the risk.
Because most deal structures do not guarantee the full consideration, the actual payments made in a transaction may vary significantly from the stated "face" value. The actual payments made depend on performance of the combined entity and those are rarely communicated and related back to the originally published "valuation multiple." Most important, multiples are a function of the past, while business value is a function of the future.
In evaluating the value of your business for the purposes of an internal transaction, consider a discounted cash flow analysis as would be performed in a formal valuation: Value = Cash Flow ÷ (Risk - Growth).
Cash flow is the cash generated by the business after fair compensation to owners, risk recognizes the required rate of return on a closely held business with the unique risk factors of your specific practice, and growth considers the firm's likely perpetual growth rate in earnings.
Some of the adjustments you'll want to make to cash flow include:
Normalize partner compensation-What would you have to pay to hire someone to do your job? Depending on the owners' roles and the size of the organization, this is typically in the range of $150,000 to $400,000.
Eliminate discretionary items, including things like personal expenses deducted through the business, spousal compensation (if your spouse doesn't work in the business), etc. Keep "normal" benefits, but remove anything that you are doing purely for tax reasons, to generate a true business financial statement.
Eliminate extraordinary items-unusual, one-time expenses or one-time big-ticket sales, for instance.
Adjust for abnormal economics such as delayed hires.
Some of the factors you'll want to consider in evaluating the risk of the specific business include:
Quality of client base;
Dependence of the business on owner(s) or key people;
Strength of management team;
Stability and growth of the local economy; and
Nature (transferability) of the revenue stream.
Of course, the higher the cash flow, the lower the risk and the higher the growth rate, the higher the value. Higher growth results in higher future cash flows, a lower discount rate and higher value. And lower risk and greater transferability results in higher value.
One important point about valuation-whether in an internal transaction or an external one-is that the value calculated is just a starting point for negotiations. The buyer will likely challenge the assumptions made about growth, expenses, timing of hires, risk factors, discount rates-and how all of those factors impact the valuation and the ultimate price they will pay, and the seller will need to be prepared to justify the assumptions made, and negotiate when appropriate. This is not a personal attack. This is just good business/investment sense on the part of both parties.
Structure Of The Deal
The structure of the ownership also impacts how much the candidate values buying in, and therefore how much they will be willing to pay. The rights associated with the ownership they are buying will impact the price they are willing to pay, including:
Will they have participation in the board or other governing body?
Will they have participation in management?
What will the voting mechanisms be?
Will they have ownership of specific assets (e.g., a client base)?
Will they have the right to block specific decisions (such as the sale of the business to an outside partner, or the admission of future partners)?
What will the terms be of the ultimate buy-sell agreement?
Will they have the right of first refusal to acquire the remaining interest when you are ready to sell?
Will they be required to sell on exit?
How the risk is balanced between the buyer and seller will also impact the ultimate price. Factors that would increase the risk for the seller, and therefore increase the price would include:
The seller is asked to carry a large note.
The purchase will happen over a long period.
The buyer experience level is low.
The price is based on client retention.
High growth is projected.
Factors that would increase the risk for the buyer, and therefore decrease the price would include:
A large down-payment is required.
A high level of bank financing is needed.
The seller's role in the future is unclear or undesirable.
The client potential is limited or in question.
A rigorous payment schedule is set.