By Alden Caouette, Kingston Ross Pasnak LLP
Projections can be a powerful tool and are fundamental to the Discounted Cash Flow (DCF) valuation approach, which is typically employed in the determination of a company’s value for transaction purposes. Projections will demonstrate the future cash flows a prospective buyer can expect from the company if they purchase it. Due to the forward-looking nature of projections, assurance may be difficult to establish especially for transaction purposes, so it is critical to identify the risks of achieving said projections.
In short, the value of a business is a product of the company’s projected cash flow and the risk of achieving that projection. This chapter discusses the key considerations for both elements that a seller should consider to maximize the value of their business.
A cash flow projection typically contains the following key elements for each year in the projection:
- Revenue growth
- Profit / profit margins
- Capital expenditures
- Working capital
- Income tax
It is common to see aggressive “hockey stick” revenue growth projections prior to a sale. However, these projections are meaningless unless sellers have a compelling story for the growth of the business, such as a new product line or key client relationships. By demonstrating how new product lines will contribute to future growth, through market analysis reports, the risks of achieving projections are reduced in the eyes of a prospective buyer. Additionally, identifying how key client relationships will support the growth projection is important to both transitioning the relationship to a prospective buyer and reducing risk of attaining future cash flows.
Profit / Profit Margins
Profit margins typically use earnings before interest, tax, depreciation and amortization (EBITDA). Sellers should consider demonstrating the continuation of the most profitable customer relationships, via transition periods or evidence of long-term contracts, to reduce the risk of profit margins dropping after the sale. Identifying non-recurring expenses are also important to ensure sellers don’t get penalized in projections for expenses that will not likely happen in the future.
Sellers should identify significant capital expenditures undertaken in the years prior to the sale, as these are some of the largest non-recurring expenses. Helping a buyer understand how much useful life is left in the company’s equipment and other capital assets is important to avoid including unnecessary, large capital expenditures in projections. This will help to increase the value of the company. Projections should also consider the capital required to support revenue growth. If a seller projects high growth, there should be a related amount of capital expenditures in the projection. Conversely, if the company expects consistent results with low growth, then projections should include little growth in capital expenditures.
This is a common adjustment on closing. Sellers should carefully negotiate the company’s “normal” level of working capital or risk losing value at the conclusion of the transaction. Like capital expenditures, working capital requirements will increase with significant revenue increases. The projection for incremental working capital should also make sense in the context of the projected revenues.
Many small business owners are eligible for lower corporate tax rates but a larger purchaser may be subject to higher general rates. However, another small business owner may still be eligible for lower rates. Maximize value and capitalize on the lower tax rates where possible. But be aware that not all buyers use the same tax rates in their projections as the seller.
Overall, the projection must make sense for the business. Providing context of the company’s stage in the business lifecycle, its industry, and the applicable macroeconomic environment are key elements in supporting projections. All parties should recognize the strengths and weaknesses of the individual business being sold and ensure the projection story aligns with the identifiable risks.
When a company’s shareholders are considering a sale, specific actions can be taken to reduce the risk of projected figures and increase assurance for the buyer, although they cannot provide guarantees on future actual results. Shareholders should ask the following questions to reduce the risk of achieving their projections:
- Have historical operating results established a pattern to support the projected operating results?
- Is there a significant pipeline or backlog of work to demonstrate support for the reasonableness of forecasted amounts?
- Is there supporting documentation for significant contracts in place, such as contracts for projects listed within the backlog and key staffing agreements?
- Is there a large expected future customer base that will reduce the concentration of credit risk associated with revenues generated from a small number of customers?
By answering “Yes” to the above questions, a seller will be prepared to demonstrate the reasonableness of projections used in a DCF within the due diligence process. This should help the seller maximize the value of their company.
Where projections remain uncertain, provide considerations to probability weighted scenarios. Reduce the risk of future cash flows by providing three alternatives: best case, base case, and worst case. Determine future cash flows by prorating based upon the likelihood of each scenario occurring in the future. Using scenario-based projections is a strong practice for high growth or newly established businesses.
Many sellers make the mistake of talking to an advisor about selling their business after a potential buyer or other uncontrollable factor forces the sale of their business. In such cases, little can be done to improve a seller’s business before a buyer values it to determine the purchasing price. A prudent seller can significantly increase the value of their business by talking to an advisor a few years before going to market with their business. In doing so, sellers can look at their business through the lens of a potential buyer and address key factors (e.g., stagnating revenue growth, sagging profit margins, key customer and employee relationships) that could influence how much a buyer would ultimately pay for their business.
When relying on projections in the sale of your business, it is important to provide realistic and reliable data. An advisor can also help identify any inconsistencies or risks within projections early on so that such items are mitigated when it comes time to sell.
Talk to your DFK advisor today about how to best be prepared when it comes time to sell your company.