Long before selling their businesses, owners start thinking: “What’s my business worth?” Or, if they are a buyer, “How much should I pay?” Properly evaluating a business is important when it come to buying and selling. Not doing so could cost you plenty.
The Drawback of “Comparable”
Bankers like to talk about the value of publicly listed companies based on its stock price and some reasonable “premium” above that price. There is nothing wrong with this approach – but what is the right premium, if any, and how do you figure it out?
For private companies, bankers often apply the “multiples” that have been established by a transaction involving some other so-called “comparable” firm. They look at multiples of revenue, net or operating income, cash flow, EBITDA, etc. But most so-called “comparable” companies are not a perfect match. They have varied product lines, management strength, scale, geographic presence, growth rates, profitability and more. Furthermore, which metrics should you use? Should you use last year’s revenue or next year’s profit? Run rate? And what about value of R&D, the balance sheet, or the “real” value of property, patents, copyrights, or trademarks? There are many factors to consider!
MBAs, economists, academics and some bankers may want to establish value by using Discounted Cash Flow (DCF) analysis. But DCF analysis assumes that you can get both sides to agree upon projected future top-line growth, expenses, investments, profit rates, and a wide range of risks. It rarely happens.
So, what’s a buyer or seller to do?
When our company assesses the likely value of a company, we may use some of these methodologies. But on top of them we layer on an approach that I learned while on active duty in the Marine Corps.
No Marine would say that because we paid for Guadalcanal with 7,100 American lives, 7,800 casualties and 29 lost ships can be applied to the “value” World War II leaders had to pay to take Iwo Jima.
Naïve approaches to valuation are how Yahoo! wound up paying $5.7 billion for Broadcast.com (and $3.6 billion for Geocities); and Time Warner agreeing to a $165 billion deal with AOL.
Marines have a different way to evaluate what a piece of ground is worth. We look at four things:
First: How important is winning this battle (transaction) strategically? Does it advance the parties towards their respective long-term strategic future goals? Because it’s all about the future, the more the transactions move towards your future goals, the more it drives interest in winning. As the economists will tell you, interest leads to demand – a key drivers of price. Does the other side have to transact? If the transaction isn’t strategically important to either side than it is probably not going to happen – and certainly not at a very high price. If winning is critical for one side, that’s different. To some extent, this correlates to a simplistic version of supply-and-demand – which after all should be the ultimate driver of value. Still, even supply-and-demand needs context.
Second: Is the timing right for this battle? The US is a master at Island hopping – picking the battles they will and will not fight. If the timing isn’t right for both sides, the deal probably isn’t going to happen – unless a highly motivated buyer is willing to pay a huge premium or a highly motivated seller is willing to sell at a discount.
Third: Is the cost of the battle both affordable and reasonable? It’s the intersection of affordability and price reasonableness that is important. The US could spend 25,000 American lives to capture Syria – but would we? Google could spend a billion dollars to buy your company – but would it? Google could afford to sell YouTube for a dollar – but would they?
Fourth: Is the risk acceptable? What is the risk of entering into the battle as well as the risk of not entering into it? “Value” can be impacted by a seller’s concerns about their own future, the future value of promises made by the buyer and many other factors. It also can be affected by a buyer’s concerns about things such as customer concentration, weak management, competition, technology, or dependency on key people. Sometimes the object is to achieve the long-term strategic mission, so there may be times when there is greater risk in not entering into a transaction.
The Marine Corps Way Works
Was Facebook smart to pay $1 billion for Instagram when it had thirteen employees, no revenue and no profit? The $1 billion Facebook paid consisted of $300 million in cash and about 23 million shares of Facebook stock, valued then at $30 per share. (As I write, Facebook is trading at $120 per /share.)
When we add the Marine Corps approach to the traditional approaches we conclude that the $1 billion that Facebook spent to buy Instagram made total sense. The deal was strategic for both sides; the timing – immediately before Facebook’s IPO (and after Instagram had been approached by others) could not have been better; the price was both affordable and reasonable for both firms. For Facebook the risks of not acquiring Instagram were significantly higher than the risks of buying the company and later having it fail.
I go into much more detail on the factors that go into valuing a business the Marine Corps Way in my book, The Marine Corps Way to Win on Wall Street: 11 Key Principles from Battlefield to Boardroom.
Recently, we advised a firm that had operated for years and never made a large profit. Its balance sheet worth was minimal. Yet, we helped them sell for more than six times revenue (and a near infinite multiple of profit). Was the buyer foolish? No! The company being sold was growing rapidly and was attracting interest from multiple suitors. For the managers, the administrative burden was growing. The managers and the other shareowners were ready to monetize their investment. The timing was right.
Read more about The Marine Corps Way to Win on Wall Street: 11 Key Principles from Battlefield to Boardroom and download a free excerpt of the book here.