Key Idea: Value Your Business
Meet Ray Smilor of Beyster Institute at the Rady School of Management, University of California San Diego. He is an expert on Employee Stock Ownership Plans and the institute is a resource for anyone who wants to learn more.
n this episode we are talking about employees buying the business and that is an option. To sell your business to anyone or any group, you must find the value of your business and calculate your EBITDA.
This is a little technical but understanding this concept and why it matters is critical to your ultimate exit strategy. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Calculating your EBITDA is easy. Take the bottom line of your income statement and add back all those items (interest, taxes, depreciation, and amortization). Simple, right? But understanding EBITDA and why it's important is what matters to you.
Q: Why the focus on EBITDA?
A: The EBITDA is probably the single most important factor in the buyer's evaluation of the acquisition target because it represents cash flow from operations. The purchase of your business is an investment from the buyer's point of view, and he or she will calculate the return on that investment. This return is generally calculated in the traditional percentage manner as well as in terms of the "payback period."
The payback period is calculated based on how many years it takes to recoup the cash and/or stock investment.
The more profitable the business, the higher the price the buyer will pay because the business will provide an economic return justifying a larger investment. EBITDA isn't the only thing the buyer will evaluate. If your business operates with a significant investment in equipment, the buyer will have the equipment appraised. What kind of capital investment will be required beyond the purchase price? If your equipment is aging and needs to be replaced, this could have a big impact on the purchase price.
Necessary capital improvements are considered separately by the buyer, that's why depreciation and amortization are not included in EBITDA.
Q: Why add back taxes to calculate EBITDA? Isn't that a cost paid from cash flow? Won't the buyer have to pay the same taxes you did?
A: You bet! There's an old Yiddish proverb, "You make your money; you pay your taxes." CPAs like to say that you can't let the tax tail wag the economic dog. Yes, the buyer will pay taxes on the profits of your business and yes those taxes will come out of the cash flow of the business. The reason taxes are not considered in the valuation of your business is because the buyer is considering your business as an alternative investment.
The same is true of interest. The buyer will take into consideration the cost of money, to be sure, but as with the capital improvements that may be required; the buyer's cost of money is independent from your cost of money. So just as the buyer will "add back" the depreciation and amortization you have recorded each year, he or she will similarly add back interest and take into account his or her own cost of financing the transaction.
If you pay yourself above industry standard, don't worry. Buyers realize this and will deduct from your overhead the salary and benefits you have been paying yourself. A new buyer will use what is called recasted numbers to determine the value your company holds for them.
Q: What is the fundamental reason a person starts a business in the first place?
A: The simple answer is to first create something of value, and then sell it to someone at a price that is greater than your costs again and again.
A "first principles" answer looks more deeply at the value creation component, then at the very nature of the agreements with the buyer, then at the leveragability of both. And both "answers" fully reflect every aspect of the mantra.
Think about it
What would you have to do differently to be more aggressive in your use of your own business valuation, and your equity and possible liquidity? Would your behavior be different if you had an exit strategy?
Clip from: Employee Stock Ownership Plans (ESOP)
Meet Ray Smilor, Rady School of Management, Univ. Calif. San Diego
SAN DIEGO: In this special episode you will meet many people who understand Employee Stock Ownership Plans (ESOP). ESOPs are keys to the future for any growing business. Though each word is quite operative, the most important is ownership.
To understand ownership, we have to understand something about the value of what is owned. It is a lot more than a business valuation. It is about business sustainability.
Ray Smilor and Dr. Robert Beyster (SAIC) are experts on the subject. Once a person is actively participating in the bottom line or the profit line of the business, once they are vested, don't you think they'd act differently and care more? Ray Smilor says that typical productivity increases 4-5% per year.
What would that do to your profit line?
Go to all the key ideas and videos from this episode...
former Director, Beyster Institute
Ray Smilor, CEO
1241 Cave St.
La Jolla, CA 92038
Visit our web site: http://beysterinstitute.ucsd.edu
Year Founded: 1971
Value Your Business
HATTIE: You've just said we have to do it right. How do we do it right?
RAY: Talk to an attorney and talk to a business appraiser. Because an attorney will help structure an ESOP.
HATTIE: Valuing the business, that is the part that I think a lot of us are afraid of. We don't even want to know.
RAY: Valuation is really a very critical part of all of this, Hattie.
You have to know, `What's my company worth?' before you can sell it either on the marketplace, to another company, or to your employees.
So this is where getting a business appraiser is important, an appraiser who's expert at valuing companies. The expert comes in and the expert will look at your financials, look at your products and services, look at your customer base and begin to get a sense of the value of the company. The appraiser will look at competitors in the marketplace and get a sense of what their values are. They'll look at public companies, private companies. And from all of this data, they'll come back and they'll say, `Your company is worth X amount of dollars.' And if it's $10 million, then the person has a couple of choices.
He can try to find a large company to buy it for $10 million. He can try to find another entrepreneur to buy it for $10 million.
Or he can say, `I want to sell it to my employees. If I sell it to my employees, I can do it through an ESOP.' And the ESOP then becomes the structure through which the company is sold and the employees buy the enterprise.
HATTIE: So give us the strategies. What are the steps we have to go through to form an ESOP?
RAY: Let's assume that there's this value of $10 million. Where will the employees get the money? They set up an ESOP, which is a legal structure, and it's technically a retirement plan, but in reality, if it's done right, it's a productivity plan. It helps the employees be more productive.
So they set up this legal structure, a trust, which is the ESOP. The ESOP then has two choices to buy the company. The ESOP can go to a bank and tell the bank, `I need $10 million. Will you put the money in the ESOP?' And then the ESOP buys the company from the entrepreneur, gives the entrepreneur the $10 million and the ESOP then has to pay the bank back over some period of time. That's one option.
When the ESOP is set up there's another option. The ESOP can then say to the owner, `Instead of going to be bank, we'll set up installment payments to you,' and over some number of years the employees, through their profits, will pay you back over time.
So either one of those options can take place to buy the enterprise. Once the ESOP is set up, all the employees must participate in it. One of the big differences, I mean really huge differences, is the tax advantages that benefit the entrepreneur.
If you sell to an individual or to another company, you pay capital gains taxes. So out of a $10 million sale, you might pay $2 1/2 million in taxes. If you sell to the ESOP you pay zero taxes, as long as you follow a few key stipulations about what you do with the money.
There's not only a terrific tax advantage to the entrepreneur, there's a terrific tax advantage to the ESOP and therefore, the employees who own the company. Because the employees can pay back the bank or pay back the entrepreneur over these installments with pre-tax dollars. Now these would be dollars that originally would go to pay taxes, but instead of paying taxes, they go to buy the company through the ESOP.
So there's a huge tax advantage for the entrepreneur and for the employees through the ESOP.