Addition by Subtraction: A Formula for Increasing the Value of a Business
When it’s time to sell a business, is the whole really greater than the sum of its parts?
It may seem the natural truth. But when a company is faced with a segment that is losing money, businesses may in fact improve their marketability — and their selling price — by divesting of underperforming assets prior to going to market. Not only will businesses benefit from this strategy, but so will the providers of capital (e.g., lending institutions).
Although valuing a business is complex, a typical approach is for prospective buyers to apply a multiple to the consolidated EBITDA to determine an enterprise value. Smaller companies often trade for lower multiples, typically between 3x to 5x normalized EBITDA, while larger firms may fetch higher multiples and price tags. Higher levels of EBITDA indicate more attractive acquisition candidates by the market.
Before going to market, business owners should consider how to maximize the consolidated EBITDA of their company. While there are many strategies for improving profitability prior to sale (e.g., streamlining operations, eliminating redundancies, renegotiation of supply agreements, etc.), one that can sometimes make the biggest impact is often not considered. Rather than investing cash flow to cover losses generated by underperforming divisions, locations, product lines, or SKUs, business owners should consider selling these assets on the business’ marketability and value prior to going to market.
When Does 2 – 1 = 3?
Consider, for example, a company generating $10 million of EBITDA in an industry that is selling at 5x EBITDA, equal to a $50 million potential valuation. If one division within this business is losing $1 million in EBITDA per year, it hampers profits and detracts from the potential overall value. With some foresight, the seller could divest of the money-losing division prior to taking the entire company to market — increasing its cash flow to $11 million by actually making itself smaller. When the leaner company’s revenue is multiplied by the same 5x EBITDA, we get a valuation of $55 million.
Beyond stemming the loss of income, the surviving business’ financial position is often further strengthened by the proceeds generated from the sale or disposal of the underperforming unit. Increasing the operating margins of the retained operations makes the company more attractive to a potential buyer. And the business can then focus on its core competencies, creating an enterprise that is well-defined and achieves its maximum market value. Even in instances where the divestiture results in a loss, if redeployed wisely, the cash generated from the sale could more than offset that loss. For example, the company might use it to update facilitates or purchase new equipment that drives additional efficiencies for its principal business — further increasing the enterprise value.
Highly Competitive Market Requires Differentiation
The Financial Times reported that buyers paid record valuations for U.S. takeover targets during the first half of 2015, averaging 16x EBITDA and far surpassing the previous high of 14.3x in 2007. However, questions are already being raised about the sustainability of this boom. Businesses interested in standing out and achieving the greatest return in this competitive market should consider what strategies could be employed now to increase EBITDA down the road. Even for businesses that are not considering selling today, this type of strategic planning will help them end up on top when they do pursue that course.
When the goal is value maximization, it’s important to take a frank look at all components, without sentimentality or bias. Continual and thorough examinations of profitability and performance of all business segments are important to make well-informed decisions. Small to midsize businesses that lack robust accounting may benefit from engaging a business valuation expert to understand their current enterprise value and assist in identifying opportunities for margin growth. Appraisers work cooperatively with investment bankers, who provide critical insight into the M&A market and help companies prepare for a sale.
Lenders as well as business owners have an interest here as well. Banks may themselves benefit from encouraging portfolio companies to explore this strategy. Sometimes an external perspective may identify options not previously considered. When executed successfully, the added cash flow provides additional funds to pay down debt or to comply with loan covenants. And by solving issues before the buyer has to, a quicker transaction is facilitated. This is beneficial to all investors of capital in the enterprise.
Divesting of underperforming business segments may be one of the simplest strategies for improving enterprise value. It is an effective way to deliver EBITDA growth and increase the attractiveness of a business investment. An independent business appraiser can provide more insight into which aspects of a company, if subtracted, may add to the value of the business.
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