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Chris Mercer |
My
strong interest in business valuations and discounted cash
flows goes back to my MBA days many years ago. This being a
favorite topic of mine, I am excited to interview Chris
Mercer and share his insights into this domain. Chris is the
CEO of
Mercer Capital, one of the leading business valuation
firms in the nation. Chris also has his own blog at
www.merceronvalue.com.
Anthony: Chris, when did you
start Mercer Capital, and what services does your company
offer?
Chris: I started Mercer
Capital in 1982 with the idea that there was room in our
local region for a business appraisal firm. Since then, we
have grown to become one of the larger independent appraisal
firms with a national and even international clientele.
Mercer Capital provides independent business valuation
services to meet a number of client requirements, including
corporate transactions, gift and estate taxes, employee
stock ownership plans, and litigation support. Mercer
Capital Advisors, our investment banking arm, provides M&A
services, fairness opinions, and other financial advisory
services to private and public companies.
Anthony: Please give us an
overview of the business valuation process and the elements
you consider when performing a business valuation.
Chris: At its simplest, the
value of a business today is a function of its expected
earnings or cash flows, the expected risk of those cash
flows from the viewpoint of relevant investors, and their
expected growth.
So, when performing business appraisals, our main goal is
to develop an understanding of the nature of each business
and to anticipate or forecast its expected future
performance. In broad terms, this means assessing the risk
of that performance and estimating its growth.
For companies that have been around awhile, this process
begins with a detailed historical analysis based on
historical financial and operating statements. The financial
analysis enables us to understand performance and to observe
any particular adjustments that should be made to the income
statements or balance sheets. The operating analysis enables
us to assess the customer base and relevant attendant risks,
such as customer concentrations. The operating analysis also
examines the supply side of the business, as well as the
distribution side, so as to understand the nature of these
operations and their attendant risks. And we have to learn
about the potential for near-term and longer-term growth of
revenues and earnings. We also must make judgments about
management and its ability to carry historical performance
into the future – or to create the bright and glorious
future we see in so many forecasts!
For newer companies, detailed historical analysis is not
possible so there has to be an incredible focus on that
which exists now and that which might or will come into
being in the future. But we will still, ultimately, be
focused on the expected earnings or cash flows and their
expected risk and growth.
Anthony: How dependent is
the valuation approach on the industry or the development
stage of the company under consideration?
Chris: Anthony, that’s a very
good question – actually two good questions and an implied
third. So if I ramble too long, reel me in!
The third question relates to the basic approaches to
valuing businesses. There are three broad approaches to
valuation called, respectively, the income approach, the
asset approach, and the market approach. The income approach
looks at the conversion of expected benefits into present
value. Particular methods under the income approach include
the discounted cash flow method and the capitalization of
earnings method.
The market approach to valuation examines value through
the lens of comparing a particular subject business (or
interest in a business) with actual transactions from “the
market.” The market may be the market for a company’s own
securities (quite limited for most private companies), or
comparisons with similar, publicly traded companies whose
stocks have active markets. In the alternative, comparisons
can be made with valuation metrics from transactions in the
sale of entire companies.
Finally, the asset approach, as employed by most
appraisers, is based on an examination of a company’s
tangible assets. While intangible assets can be separately
valued, their collective value is generally best estimated
using methods under the market or income approaches.
That’s a mouthful, but it's helpful to talk about
valuation of companies in specific industries or in various
stages of development.
While the specific application of valuation approaches
will differ from industry to industry, appraisers will
consider each of the three general approaches in every
valuation. Some industries are obviously income-oriented,
such as software, service and distribution, and value-added
manufacturing. Others, while income is clearly important,
are more focused on underlying assets values, like REITs,
construction, and others.
Most business owners believe their particular business or
industry is unique – and to some extent, they probably are
somewhat different than other companies. And virtually every
industry has a particular vocabulary that appraisers must
learn – very quickly!
Some industries do require specific knowledge or
understanding on the part of appraisers, particularly highly
regulated industries like banks, utilities, and to a lesser
extent, certain aspects of the media. While the principles
driving valuation are not different for these industries,
their regulatory structures may require extensive knowledge
just to be able to understand what is going on with them,
the risks associated with their cash flows, and their
ability to grow.
The development stage of a company will also influence
the valuation methods employed. Well-established companies
will normally be valued using methods like the
capitalization of earnings and comparisons with similar,
guideline public or private transactions. Start-ups, on the
other hand, are valued based on multiples of hope. (Just
wanted to see if you were listening!)
Start-ups and earlier stage companies are valued based on
the expectation of future cash flows, and their estimation
can be exceedingly difficult. Companies based on the
development of certain technologies can be even more
difficult to appraise. They may not be planning to utilize
the technologies themselves, but rather to sell them or to
license them. In that case, the expected cash flows to the
technologies are derivative from the expected cash flows of
the ultimate user. And these cash flows may be based on
expected future earnings, license fees or royalties, or some
combination of the above.
Anthony: What purpose would
a valuation exercise serve in the case of a technology
start-up?
Chris: A technology start-up
may require some form of valuation in order to determine the
beginning ownership interests of the starting entrepreneurs
and the venture capital providers. Obviously, the VCs will
do their own valuation, which will be based on expected
returns. These valuations are typically done on an
enterprise basis. It could be in an entrepreneur’s best
interest to have a qualified appraiser perform an analysis
to be used as a negotiating tool with the VCs.
After formation, though, if shareholders in a start-up
are confident of long-term success, it could be a good idea
to conduct a valuation analysis for illiquid minority
interests in the company. Gifts could then be made to
children, charities or churches at discounted prices. If the
company is later successful, there would be tremendous
appreciation potential for the donees.
Anthony: Could you walk us
through the valuation of a hypothetical case?
- Strong team in place, a promising technology, and
future products with high demand.
- The company is expected to burn through $15M in cash
before breaking even in 2010.
- Revenues are expected to start at $2M in 2007 and grow
75% every year thereafter, reaching $10.7M in 2010 and
$18.8M in 2011. Revenue growth is expected to drop to 50%
in 2012.
- The company expects a net profit of $3.8M or 20% in
2011 and $5.7M in 2012.
Chris: There are relatively
few occasions when appraisers are called on to provide the
fair market values of start-up business plans. Private
equity groups employ investment strategies based on expected
returns over anticipated investment horizons. Entrepreneurs
naturally want to sell the grand, but unproven, profitable
future. In start-up deals that are funded, actual ownership
splits (and implied valuations) are matters for negotiation.
Entrepreneurs want to sell discounted cash flow (DCF)
"valuations," while private equity groups want reasonably
protected downside risk in tandem with wild potential in
successful scenarios. Final prices of an entrepreneur's plan
(i.e., ownership splits) are functions of the supply and
quality of entrepreneurial deals, the availability of
private equity, and the competition between private equity
groups. Potential valuation swings can be quite large.
Let's examine the case you described more directly. In
order for the entrepreneur to realize his vision, he must
first obtain the $15 million of capital necessary to cover
anticipated losses. The entrepreneur’s business plan
provides the details of the assumptions in the plan and the
cash flow expectations. The pricing negotiation is a
multivariate affair.
Assume that everyone agrees that the terminal multiple
will be 20x expected earnings at the end of 2011. A likely
range of equity splits for negotiation might look like the
table we prepared.
The table is constructed to show implied valuations, or
agreed values of the business plan based on DCF analysis.
The range above is from $17.5 million to $25 million. A $25
million “valuation” provides for a 60% - 40% split for the
private equity investors and the entrepreneur(s). And the
private equity investors would achieve a 29.5% internal rate
of return, or IRR, on their investment.
At the other end of the table, with a $17.5 million
“valuation,” the private equity split is about 86%, with 14%
remaining for the entrepreneur(s). The IRR for private
equity rises to 37.4%.
The range of splits is quite wide, and the ultimate
returns of both groups are determined by the final
agreements regarding the splits.
The nominal “valuation” at the time of the investment
doesn’t really matter, except for maintaining the perception
of value for possible future rounds of investment. The
critical economic factor for both private equity and the
entrepreneur(s) is the equity split. After that, what
matters is the ultimate value at the time of future
liquidity events. At that point, everyone hopes that the
future multiples will be 25x, 30x, 40x, or more.
This short description has been based on an implied
agreement between private equity investors on both the
business plan and the terminal multiple, and ensuing
negotiations. The world is not so simple. Add in multiple
forecasting scenarios showing downside results and different
assumptions about the expected future values, and you can
see that the negotiation process can be complex.
In any event, there will be an agreed split (or range of
splits based on future performance) in funded deals.
I don’t know if I’ve answered your question completely,
but I hope this provides a flavor of how “values” are set in
such deals.
Anthony: How much deviation
can one expect the valuation in an actual transaction to be
from the valuation derived from a study or appraisal?
Chris: The conclusions of a
valuation study can differ significantly from the price
actually obtained in a transaction in the same general time
frame. Differences can arise for several reasons. First,
valuations are typically done based on a fair market value
basis, which assumes that hypothetical and typical
willing buyers and sellers - - both equally informed and
both with similar capacity (to do or not do the deal), and
neither under any compulsion - engage in a hypothetical
transaction.
Real transactions are entered into by real people.
These people may be less than equally informed, may be
operating under compulsion, and have differing capacities to
do or not do a particular deal. Individual buyers make
acquisitions based on the best prices they can negotiate in
the context of their evaluations of value to them. These
values can vary, sometimes widely, from the values developed
in an appraisal exercise.
This answer may be less than satisfying, but it is
nonetheless accurate.
Anthony: Some entrepreneurs
consider debt as an alternative to equity financing. Does
one method lead to a better valuation over the life of the
venture?
Chris: There are several ways
to look at this question. An entrepreneur might want to
borrow money for a start-up and not have to give up much
equity in the deal. However, knowledgeable purchasers would
know that there is not sufficient return potential in a debt
instrument to justify the investment. So equity in the form
of options or warrants would likely be part of the deal,
since most investors will likely discount the likelihood of
receiving interest payments.
In less risky start-ups (if there is such a thing), an
entrepreneur may desire to capitalize an enterprise largely
with debt so that the early “returns” can be returned to him
or her in non-taxable form. But few start-ups can stand the
burden of interest expense in the early years.
The bottom line is that start-ups, particularly in the
tech areas, need to be funded with equity, by whatever name
it is given. In the final analysis, whether financed with
debt or equity, what most entrepreneurs are interested in is
maximizing their post-financing (whatever round) ownership
position.
Anthony: What are the common
mistakes that drive valuation down?
Chris: Valuation is the
present value of expected future benefits. To have value,
there must be the expectation of future benefits. To have
such expectations, the cash that is being consumed today and
tomorrow must be invested wisely in order to achieve the
expected return. One of the biggest mistakes in
well-financed start-ups is overspending. If an entrepreneur
raises capital based on a business plan and then falls short
of that plan and has to raise additional capital, the next
round will likely be obtained on less favorable terms, i.e.,
at a lower relative valuation than if earlier returns had
been achieved.
In more mature companies the basic valuation equation of
V = E / (r – g), i.e., the Gordon Model, can be expressed as
V = E x M, where E is a measure of earnings and M is the
multiple applied to those earnings. I hate to be simplistic,
but the biggest mistakes that entrepreneurs make that cause
lower valuations relate to:
- Having too little E. E = TR – TC. So, earnings that
are too low can be the result of inadequate attention to
the top line, or Total Revenue, and too little attention
to managing Total Costs. Earnings and value lie in the
difference.
- M = 1 / (r – g). The multiple is a function of
expected risk associated with future cash flows and with
the expected growth of those cash flows. Entrepreneurs
hurt the value of their businesses, naturally, when they
fail to grow (g) to their potential (that lowers
future TR and E. Importantly, entrepreneurs diminish the
value of the businesses when they fail to manage
enterprise risks (r).
These comments may seem simplistic, but if entrepreneurs
will keep them in mind as they make daily decisions that
have a cumulative impact, they will consistently generate
more revenues, earnings, future growth that is perceived as
more secure (less risky), and more value.
Anthony: What can
entrepreneurs do to maximize value?
Chris: The first thing is to
remember what not to do – those things that drive value
down! More seriously, though, entrepreneurs should develop
their businesses in such a way that they are as ready for
sale as possible, given the stage they are in.
I am working on a book now with the title, Is Your
Business Ready for Sale? And I have given a speech of the
same name numerous times. The basic idea is that a focus on
readiness keeps as many aspects of a business turned in the
right direction as possible. Years ago, I worked for a bank
whose president at the time gave me some good advice. He
said, “Chris, you don’t cut your best deals when you’re
begging!” And a business that is ready for sale is not in a
begging mode.
The concept of Ready for Sale™ is more involved than we
can cover in this interview, but I can leave your readers
with an idea that is really helpful – at least it is helpful
to me! Think in terms of keeping your business READY.
R Risks – manage them
E Earnings – focus on them
A Alternative Costs (Opportunity Costs) – Keep them
in mind. They are real
D Driving Growth - a necessity
Y Year-to-Year Comparisons – Keep in mind that what
you do this month, quarter or year is building the record by
which your business will be judged and valued.
Anthony: Why do you blog and
what impact does your blog have on Mercer Capital?
Chris: I recently wrote a post
on my blog, Mercer on Value, entitled “Why Do I Blog?”
Readers can find it at
http://merceronvalue.com/archives/2005/08/why_do_i_blog.html.
I gave my “top ten” list of reasons why I blog, and I ended
the post with the following thoughts:
Upon further reflection, I suppose there is an
eleventh and overriding reason on my "top ten" list of
reasons why I write and blog. Over the years, my writing
has introduced me, either personally, or through
telephone calls, correspondence, or e-mail, or
opportunities to travel and speak, to literally
thousands of interesting people I never would have met
otherwise. Many have become clients and/or friends. Many
have stimulated my thinking and encouraged me to keep
on. And knowing that these many readers are out there, I
am continually challenged to maintain an appropriate
intellectual honesty to my writing.
Anthony: What advice can you
give today’s entrepreneurs?
Chris: For most entrepreneurs
and business owners, success is a long-term game. Don’t be
discouraged if your business is not an instant success.
Persistence pays.
Always think of your business as a business. This may
sound obvious, but it can become a place to be, a place to
work, a source of income, and a lot of other things. Never
forget while all of those things are happening that is still
a business and run it like one.
Be READY.
Bio
Z. Christopher Mercer is the founder and chief executive
officer of Mercer Capital which provides business valuation
and investment banking services to a national and
international clientele. Chris began his valuation career in
the late 1970s and has prepared, overseen, or contributed to
hundreds, if not thousands, of valuations for purposes
related to M&A, litigation, and tax, among others. He is a
prolific author on valuation-related topics and one of the
most sought after speakers on business valuation issues for
national professional associations and other business and
professional groups. His most recent book is entitled
Valuing Enterprise and Shareholder: The Integrated Theory of
Business Valuation (Peabody Publishing, LP, 2004), which
assembles the various valuation concepts encountered by
business appraisers every day into a theoretically and
practically consistent whole. The reader views financial
concepts not as unrelated, but as part of a complete and
clear picture of business valuation.
www.mercercapital.com.
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