Navigating Business Valuations: Internal vs. Open Market Perspectives

25 Feb Navigating Business Valuations: Internal vs. Open Market Perspectives

Shoot The Moon

Navigating Business Valuations: Internal vs. Open Market Perspectives

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EPISODE TRANSCRIPT

Mike Harvath  00:07 

Hello and welcome to this week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket world headquarters in Bloomington, Minnesota. As you know, revenue rocket is the world’s premier growth strategy and M&A advisor to it, services companies. With me today, on today’s podcast is Ryan Barnett, my partner, Ryan, how are you? 

Ryan Barnett  00:27 

Hey, Mike, I’m doing well. Thanks for having me on here today. In our work, we are M&A advisors for IT services companies. So we work with managed service providers, application developers, channel partners, cybersecurity firms, and anyone that really offers a service that’s affiliated with technology as part of their their offerings, we do a lot of work in this market. In order to be a successful M&A advisor, you really have to understand the valuations that happened in this space and and as part of our work, we’re always doing valuations. Every day we’re doing another valuation for another firm, and what we want to talk today is what’s the difference between a valuation that you may conduct on your behalf compared to a valuation that may be done for an open market, and why that’s important and some things to consider. Mike, you brought out this topic today. I’d love to hear a little bit more about what, what’s on your mind. And let’s just start really, really big level. You know, what is a valuation? And why is a valuation for an IT services company Important? 

Mike Harvath  01:36 

Sure thing. Ryan, so you know, I think most people that start IT services companies generally begin with the end in mind they think at some point they’re going to exit it. You know, tech enabled, services companies. IT services companies are very, very rarely passed down from one generation to next, versus other types of businesses, which often are, you know, manufacturing companies oftentimes are moved from one generation to the next, you know, specialty retail, I think of hardware stores and sometimes, you know, quick serve restaurants, things like that, are oftentimes multi generational in nature. And so, because IT services, companies are not, you know, understanding the value of that equity as you continue to build and grow the firm is super important. That’s typically provided by a firm like Revenue Rocket, who does outside valuations, who has expertise in the market, understands the comps, just like real estate comps. Companies have comps based on their profile and understand and have a team that facilitates these valuations pursuant to both what we would call open market transactions, where a buyer is someone other than someone involved with the business, or in some ways, in what would be a trade inside or within the partnership of the equity that’s owned. And so those valuations and how they play into the building of equity, how you manage them as probably part of the single largest asset in your your portfolio, asset, portfolio, or your portfolio wealth, is important. 

Ryan Barnett  03:14 

If I look at digital, holistic level valuation, is going to be essentially the value of the entire business, of what it’s worth at a point in time based on the financial performance of the firm relative to other firms that are in the market tier today. All right, we’ve got a valuation established. And why would a firm look to have a valuation done when it’s internal, face facing. You know, we work with a lot of companies that have a variety of ownership structures, including multiple partners. That seems like if you have multiple partners, you’d want to have them all on the same page of what the value of the business is, right? But tell me why? Why is it important for a company to have an internal facing valuation? 

Mike Harvath  04:04 

Yeah, I would say that you know not vastly different than your stock portfolio. You want to know what you know that those equities are worth, certainly your equity in the business, whether you own all of it or a portion of it. But you want to know that too, and the way you do that is through evaluation. Oftentimes, we have clients, since we do a lot of these valuations on a monthly, quarterly, yearly basis, seek to get one done annually, just for their own sort of portfolio management. What is the business worth? What percentage of that do I own? How should I consider that equity as part of my own net worth as an individual. Likewise, it can be used as a tool to implement a best practice around corporate governance. Should there be a transfer of equity in the coming months or year? We certainly strongly encourage our clients to do an annual valuation so that, at a minimum, they can talk about how effective they’re executing on their growth strategy and growing the business value is certainly a great Bellwether and a measure for determining if you’re executing well, and it provides a great context for a discussion with your partners about, you know, are we making the right level of investments? Are we realizing a return on those investments pursuant to our kind of return on the equity that we have in the business? But but more importantly, you know, if you have multiple partners, I think it’s critically important to be able to have that valuation done, not only to help shape the way you plan and plan to invest and grow the business in the future, but also understand how you know effective your strategy have been in the past, and to formulate any potential equity transactions with those partners that will occur in the coming year. You know a best practice, and you certainly can talk to your corporate attorney about this, but is to formulate a valuation on an annual basis so that you can bake in a sort of trading price or methodology into your into your buy sell agreement or your shareholder agreement with your partners. And if you do that effectively, then should someone unfortunately, unexpectedly die or have to exit the business for some reason, you can have a context around, how do we fairly transact a deal with those equity holders with a schema that can be easily executed? Certainly that would be considered a best practice and a good business case, also a good reason to do an annual valuation of your business. 

Ryan Barnett  06:45 

I just want to emphasize the point, Mike, I think you nailed it. You have to have a Buy Sell agreement in place, and you have to be able to work with those agreements and those partnerships. And part of that can be a matter of in those agreements saying there is going to be a valuation done on a periodic, periodic basis. Mike, if you know, assuming that company is going through valuations and they are using it for an internal documentation to help facilitate the transaction, kind of between internal parties. How does that? How do the results of that valuation differ compared to that if you’re, if you’re in an open market or a third party, M&A transaction? 

Mike Harvath  07:31 

Yeah, good question. Ryan, so, you know, an arm’s length transaction where there’s multiple bidders to sell your business, well, you know, there’ll be a number, there’ll be a value for that and and primarily that value is driven by, you know, three things. There’s a financial analysis of the business pursuant to how the business is performing, and that’s generally based on a multiple of your profit or multiple of e beta. There’s certainly a comps, if you will, sort of analysis that says, hey, here’s similar companies to mine that have traded successfully done transactions in the last let’s say period of time could be as short as a month, or as long as probably six months. And those are used as a sort of another data point. And then there’s your discounted cash flow analysis, which has to do with, you know, discounting your forecast of cash flows back to today, and discounting those for risk. And I think all those three data points and coalesce around a number that should should be pointing at what would be considered fair value in an arm’s length transaction. Now, if you’re going to do an internal trade with your partner in a business, typically those deals trade at about 20% discount, give or take to an arm’s length transaction, and that’s typically what we’ve seen in the market. And generally, if you go to any you know authority around valuation, and they’re doing a valuation for your firm pursuant to an internal trade, because of what we’ll oftentimes call a limited market trade, because there’s usually one buyer and one seller, which is a corporate, the stockholders the seller and the buyer is the corporation, or you as a partner individually in the business, it’s generally a guaranteed payment, cash type payment or seller note, combination of both could still be appropriate. And you know, it’s just not a competitive environment. I mean, you’re coming to a number that you know is going to work for everyone with limited competition, that deal will trade about 20% discount, and that’s typically what we see in the market.  

Ryan Barnett  09:47 

Things like the open market, ability to attract more buyers is going to press that valuation up. So the buyer pool is going to be higher. Your even a multiples may even be higher based on. The the methodology that you’re using, as you may if you’re transferring, well, to a shareholder, you may not want that price to be as high. If you come to some kind of agreement with that, an outside market will likely just pay more, because there’s further for that strategic control compared to an inner person, and then just the the funding of that, of that deal. So competition always drives more deals up. If this just internal only, I can see why, why that’s going to be a bit lower. Mike, when you think about this, is there a what kind of companies can provide valuations, and is there any kind of regulations or regulatory bodies that are that deal with valuations that that people should be aware of. 

Mike Harvath  10:47 

Yes, so certainly, valuations can be provided by your accounting firm. They have the, you know, appropriate trained staff to do that. Some of the challenges with using an accounting firm, typically, is they have limited experience in your market, they certainly know how to do, you know the value of the cash flows and the DCF model, but don’t necessarily have exposure to private to private transactions, which you know certainly can flavor a deal. And I think in many ways, are some of the most important components of a valuation. As you can imagine, there’s M&A advisors such as ourself that can do valuations, because we do a lot of them pursuant to our client work, particularly in representing buyers to the market. We’re always looking at potential sellers and valuing their business, trying to get you know transactions completed, or if we’re representing a seller, we need to establish a baseline valuation in order to bring them to market, to understand kind of what market based price is. There is some authorizations and certifications in the valuation space. There’s an authorization called a certified valuation consultant. And essentially what that is is it’s a day long seminar, maybe a two day seminar. I get as much as two days, depending on the certifying authority, to just discuss these approaches that are what are considered normative. It is not required to do valuations, I think, as a practical matter, most M&A advisors and valuation consultants and accounting firms are not CBAS or certified valuation analysts certified valuation of them. But certainly that’s another way to evaluate whether someone you know has done valuations on the path. I certainly think a better measure to determine a firm’s ability to do valuations is, how experienced are they in your space? How many have they done this week, last week, in a month, quarterly or annual basis? And pursuant to what were they pursuant to real M&A transactions or standalone valuations? I think in many ways, valuations that are supported or support M&A transactions, because they’re vetted against willing buyers and willing sellers, are of the most value. And can certainly allow that person doing the valuation to bring that experience to bear in valuing your business in a meaningful way. 

Ryan Barnett  13:33 

That all makes sense. Mike, that industry expertise has got to be paramount, the technical ability to actually be able to do the work and understand the data that you’re seeing and the really the industry experience with other firms that are similar. That’s not something that’s easy to come by. Come by. I mean, you have to actually be in the work and doing the work in order to to have that expertise, to go there. This all makes great sense. Mike, if what advice can you give to people for just that periodic valuation and and what other thoughts might you have on this topic? And it was pretty condensed here, but would love for you to hear any other other thoughts you’ve got. 

Mike Harvath  14:23 

Yeah I think it’s always a good idea to understand about your business, especially if you’ve grown it materially since the last time you’ve done that. You know, I think a best practice is to do evaluation annually, certainly understanding where the business value is now will formulate your strategies coming up in the next year. If you get in a rhythm of doing it annually, it makes it easy as an input to your strategic planning process, not to mention the fact that if you do that, it can support a Buy Sell agreement, if you architect with your lawyer, a Buy Sell agreement that talks about how. Shares will be traded internally as it relates to either a multiple of profit or some other mechanism, or, you know, supported by that external valuation is probably the best way to do it. It will allow you to, you know, move quicker in the you know, event of, like I said, a need of a shareholder to exit, or unfortunately someone dies unexpectedly, or maybe they need to sell that equity in support of a divorce or some other personal situation, you’re going to be able to move much more quickly and likely more cost effectively if that buy sell agreement is lined up and you have your annual valuation done, not to mention, you know, the value of doing an annual valuation also supports any potential validation of offers that might come over the transom or be non solicited. Someone calls you and says they have an interest in buying your business, understanding the context of kind of where the business is valued and has been valued more recently can formulate vetting whether someone is serious or whether they’re just, you know, kind of low balling to try to acquire your business. And you know, certainly having paper to valuation at least within the last 12 months, will help formulate those discussions as well. 

Ryan Barnett  16:26 

And there seems like there’s no other simpler scorecard than the value of the business. And if we look at companies that are doing well and the valuations are increasing, that’s because their revenue and profit are increasing. So the better the company is doing, the better that valuation is going to be. And that can be somewhat just the simplest measure there is. 

Mike Harvath  16:50 

Absolutely, absolutely. And I think you know, again, keeping in mind that, you know, most of our clients, the value of their business is their single largest asset, and you know, managing that, having key knowledge to what that asset is worth, where a transaction may occur, should you need or want to sell that asset, or how you might trade amongst equity holders of that asset, I Think, is always, you know, certainly a good move in just being prudent with financial management. 

Ryan Barnett  17:26 

Yeah that makes sense. Well, Mike, is an interesting topic for today. I appreciate you digging in. I’ll leave it to you for any closing thoughts. 

Mike Harvath  17:36 

Yes, sounds good. Ryan, thanks. You know, with that, we’ll tie ribbon on it for this week’s Shoot the Moon podcast. I encourage all of you to tune in next week as we share more sort of tips and tricks of M&A and the world of tech enabled services, as well as unpack lean growth strategies that we’re seeing working in the market with that make it a great week. Thanks a lot.