By Dan Hammaker for Axial
Most CEOs will tell you they have no need for a banker. Most CEOs are also great liars.
The truth is, having relationships with investment bankers, regardless of whether a company is undergoing a transaction or not, grants a CEO access to the information they need to do their job, which is to grow and maximize the value of their business. Here are five vital things a CEO can learn about his business by developing relationships with and engaging in conversations with investment bankers.
There are two common ways to look at the value of a company, and CEOs should be aware of their differences. Enterprise Value (EV) can be thought of as what a business is worth based mostly on its common stock price, which is often derived in large part from the health of the balance sheet. Fair Market Value (FMV) considers market conditions and buyer demand in addition to EV.
Unlike FMV, CEOs can control their company’s EV. That number not only illuminates the overall health of the business, but it can also reveal the strength of KPIs (key performance indicators) that drive valuation. If a CEO seeks to maximize the value of her company, knowing valuation KPIs is not optional – lacking that knowledge risks failing to address problems at the company before they cause irreparable harm to its EV.
Since EV’s primary component is the value of a company’s common stock, its figure tends to be grounded in whatever’s been paid for a business in the past. FMV, however, is more forward looking – it seeks to depict what a future offer should be for. Rarely can EV exceed FMV, but often a buyer will attempt to catch a CEO off-guard by offering a number in between EV and FMV. CEOs who don’t know FMV risk accepting a spontaneous offer that’s too small or passing on a deal they shouldn’t refuse.
Industry Multiple Comps
The EBITDA multiple has grown to become the industry standard that measures a company’s FMV. Since companies in the same industry and size-bracket should expect to face similar market conditions and buyer demand, they tend to share EBITDA multiples as well.
CEOs benefit from knowing the multiples being commanded by companies both larger and smaller than theirs by being better able to calculate their own growth strategy. Consider, for instance, the example of the CEO looking to grow. He might see new opportunities for expansion, but that expansion is unattainable without a capital outlay. No matter – he’ll just take out a loan or raise equity.
On the other hand, because bigger companies command higher multiples, that CEO might first consider an acquisition. He can buy a small competitor at a low multiple, vault his company’s size into the bracket where multiples are higher, then leverage his new market influence to get better terms on a loan or a higher price on his equity, either of which allows him, in theory, to invest more and accelerate his growth trajectory. Such a strategy cannot be conceived without first knowing multiples above and below his status quo.
As EBITDA multiples and FMV imply, valuations exist relative to the market. As a result, even though a CEO might be growing her company, the company could effectively be shrinking if all of her competitors are growing faster.
Thus, to grow is not enough – a CEO must find ways to accelerate her company’s growth rate past that of the competition. Investment banks, with their constant involvement in industry transactions, must command a strong grasp of how fast companies of different sizes in an industry are growing. The savvy CEO will use this to benchmark her company’s current performance against that of the competition and establish goals for the future accordingly.
A line of credit is a standard tool in the CEO kit used to smooth seasonal valleys in revenue, finance minor repairs, and cover incidental expenses. However, as in the previous example regarding the CEO looking to grow, sometimes a simple credit facility won’t match the investment necessary to take full advantage of a company’s growth potential.
An investment banker can help a CEO understand which credit option will maximize opportunity while minimizing losses in financial flexibility. When considering the many forms debt can take – from junior capital to senior debt, mezzanine to A/R financing – knowing the differences in terms and rates gets complicated quickly. Investment banks can not only offer a sense for what type of debt best fits a CEO’s needs, it’s likely that he can also bring a number of providers to the table who are interested in having a conversation.
5-Year Valuation Target
For CEOs maximizing growth in the near future but looking to plan further out, knowing what their company can be worth down the line is an important metric. Using the information they’ve gathered about what a business is worth today and how quickly it should be expected to grow, most investment bankers can provide a 5-year valuation target for the companies they advise. What’s important to note here is that investment bankers also bring industry projections that add color to otherwise standard future predictions. These types of insights include market expectations, buyer behavior, seller indications, and more.
CEOs get paid to maximize the value of their companies, but in order to do so, they need to supplement their internal prowess with an understanding of what’s going on around them. Believe it or not, market expertise is worth talking to an investment banker about.