How Your Balance Sheet Impacts Business Value
Business owners should consider the following aspects of their balance sheet when deciding to sell.
A balance sheet is one of the most common starting places for buyers when attempting to assess the value of your company. The following items that flow through your balance sheet may impact the value of your business more than you think.
Most businesses would expect to see relatively consistent annual capital expenditures. On the other hand, a company that is growing or has growth plans would typically have capital expenditures that are greater than the average depreciation expense. This shows investment in the business with stated growth plans that are rather aggressive, but are not matched with corresponding historical or planned increases in capital expenditures. This shows that the company is just hoping for growth instead of truly creating it.
Capital expenditures can impact value in two key ways. If ongoing maintenance capital expenditures are consistent and represent a significant component of otherwise "discretionary" cash flow, this shows a relatively capital intensive business or a business with a slate of older assets that need replacing, and cash flows would be adjusted to show the ongoing nature of these cash outflows. This would reduce the value compared to a business that is not capital intensive or has a newer group of assets with a longer life and a delayed requirement for additional investment. If, on the other hand, the capital expenditures are fairly lumpy and are followed by periods of growth, this shows a business that is building capacity and, although capital expenditures would be considered in forecasting future cash flows, future cash flows would reflect a growth profile because of the consistent investment in additional capacity.
Remember, ultimately, it is a metric known as free cash flow (FCF) that buyers are looking for in your business. FCF is the measure of how much cash a business generates after accounting for capital expenditures, such as buildings or equipment, and is the cash that can be used for expansion, dividends, reducing debt or other purposes. Therefore, while profitability is one measure of the value of the business, FCF is ultimately just as important. In simple terms, know the difference in your business between the capex that is required to maintain current profitability and the capex required for any projected growth.
Redundant assets are assets that are included on the balance sheet (owned by the company), but are not required for the ongoing operations of the business. Some examples of redundant assets are:
- Marketable securities held by the company in a brokerage account
- Corporate retreat or vacation home
- The land and building that the company operates from
- Cash surrender value of life insurance policies
- Golf course membership
Let's take, for example, a company that has cash and equivalents sitting on the balance sheet of approximately $300,000. Also included in other non-current assets is the company-owned retreat in Palm Springs, Ca., recently appraised at $500,000. We would consider these items as redundant assets in assessing the value of the business, in concert with an assessment of the working capital, (above) whereby we determined that the company owns its lands and buildings. We will also consider these redundant assets because if the company did not own them, they could simply lease the same or similar facilities to operate from.
The reason these are considered redundant, or excess, is because if any of them were removed from the business, the business results would not be unduly impacted and should the business be sold, these assets would not likely be included in a business transaction.
Corporate-owned real estate has more to do with a business owner's overall wealth than it does with the value of the business. Many business owners we deal with also own the commercial real estate from which their businesses operate. Generally, business owners seem to be in tune with the value of their real estate holdings, but not necessarily how the real estate can impact the value of their business.
Sophisticated purchasers will attempt to purchase the business and real estate from a business owner and proclaim that the business requires the premises to continue operations, so they should be sold together as a package. While that may be true, it is extremely important to value each asset separately - the business as one asset and the real estate as the second asset.
Consider the case of Inland Metal Inc., in the following example, as a business that owns their real estate and how the different treatment can result in two dramatically different levels of proceeds to the owner.
As shown in Scenario B, deducting rent payments from EBITDA may seem counter intuitive, but you will note that it results in greater proceeds to the business owner.
The simple reason is that commercial real estate is seen as a lower risk profile asset than an operating business. The reason is that all commercial real estate needs for it to generate a return on investment is a tenant in place that is reliably paying rent in the short term and that is expected to be in place for the long term. As a result, there is a consistent spread between real estate multiples and business multiples, reflecting the differing risk profiles of each asset.
Although Equicapita does not acquire real estate for its investment portfolio, we do have relationships with funds that specialize in this and we are always willing to discuss a proposal where the real estate and/or the business you own is part of a transaction.
Get a Balanced (Sheet) Perspective
We've all heard that numbers don't lie, but they also do tell a story. Be sure your balance sheet is telling the best possible version of your business' story when you're deciding to sell. The impact on your business valuation could be significant.
Written by Equicapita Income LP
Equicapita's model is to acquire established, private small and medium sized enterprises (“SMEs”) located primarily in Western Canada. Equicapita investment drivers are to acquire operating companies at attractive valuations, with a history of generating sustainable cash flow and proven management teams.