Are you creating value or .......destroying value

Most large corporations know and understand their cost of capital. It is the yardstick by which most measure success and the hurdle rate many use to determine whether to undertake a project ......or not.

Is the cost of capital for small to mid market business owners an important statistic to understand? I believe it is because any business owner who is not getting a rate of return on their investment in excess of their cost of capital is ...... well......actually destroying the value of their company.

The cost of capital consists of 2 components- debt and equity. It is typical for these numbers to be summed up in the Weighted Average Cost of Capital (WACC). For purposes of this article, we will simply consider the cost of capital to be the same thing.

For debt, the calculation is simple; what is the interest rate you are paying for the debt currently on you books. Cost of Equity is a bit harder to quantify. No one, like a bank, does this for you. You have to factor in many variables such as opportunity costs, and most importantly "Risk". Risk is that all encompassing term that attempts to quantify how sure the stockholder (owner) is that they will get their initial investment back (at a minimum) and how likely they will get the return they expected to get on their investment. Sounds complicated but, it doesn’t have to be.

Many publicly traded, large companies enjoy an overall cost of capital in the high single digits at this time (7%-10%) based on the ease in which they enter the equity market (stock exchanges) and preferential interest rates afforded to them by banks, as well as, their ability to issue their own debt in the form of bonds. Certainly, the small to mid market business owner can borrow money (debt) close to the cost (interest rate) that a large company can, although it is still more economical for them to do so. Small business owners can borrow money with an interest rate that can range from 7% to 12%-20% depending on their funding source. The real difference appears on the equity side of the equation. Public companies can generate cash by selling company stock on one of the stock exchanges. Their cost of equity is typically still in the high single digits due to a myriad of factors, not the least of which is the risk to an established, large company is significantly less than the risk associated with a small business that may be only a phone call away from oblivion.

So, what is the cost of equity for a small to mid market business? Does anyone have any data on what those numbers are? Pepperdine University and Midas Nation (Rob Slee's group) have attempted to quantify private companies cost of capital by coming up with the Pepperdine Private Capital Market Line:

As mentioned earlier, the cost of debt for privately held and publicly traded entities are fairly similar but, as we move toward the equity side, the difference becomes very pronounced. At its pinnacle, the cost for privately held businesses that is funded solely by equity is approximately 40%, while their publicly held, “big brother’s” cost of equity is about 10%. That means that if a privately held business was funded completely by equity (likely owner cash) the expected rate of return on that investment is over 40%. Any rate of return below that threshold is actually destroying the value of the company. To be clear, most privately held businesses have a capital structure that includes both debt and equity but, the typical small business has a much higher percentage of equity than debt in the mix. It is very common for a small to medium size business to have an overall cost of capital in the 25%-35% range. Although those numbers are less than 40%, they are still significantly higher than for a publicly held corporation. Small to mid market businesses require this significantly higher rate of return due to the risk associated with them.

So, do you know if you are creating, or destroying, the value of your company?

Do you know your cost of capital?

Cliff Olin, CM&AA, CEPA and principal at Olin Capital Advisors, a small to mid market, mergers and acquisitions advisory and exit planning firm. He can be reached at colin@olincapital.com

Selling Your Business: It was the best of times ……it was the worst of times……

Originally published Dec 2010

Many small to medium size business owners wrestle with the question: “When is a good time to put my business up for sale?” The answer is typically influenced by several factors including:

·         the national and local economy

·          the availability of capital (bank financing)

·         market demand

·         specific facts and circumstances of the business

Attempting to “time” the Mergers & Acquisitions Market is about as difficult as trying to time the stock market. Once you consider typical market time for a small business to transfer of about 12-18 months, one’s ability to accurately choose the time to start the process is haphazard, at best.

Worst of times …………

Well, let’s face facts, the past 2 years have not been good ones for the private Mergers and Acquisitions Market. The national and local economies have experienced negative trends, bank financing has been extremely difficult to procure and, in large part due to the tightening of credit lines, companies have decided to stockpile cash rather than invest in growth through Mergers or Acquisitions (M&A). Overall, the deal volume has also fallen from the historical highs of 2007-08 of approximately 1,600 to about 860 deals in 2010 (to date) according to Business Valuation Resources, a leading provider of business transactions. The prices that active, private (versus publicly traded companies) M&A participants are willing to pay have also been trending downward since the 2007 market as identified in the deal chart below:

The chart identifies median valuation multiples companies paid to acquire another, based on three indications of a company’s financial performance.  As you can see, most multiples have been trending downward since 2007. Bottom line: buyers have been paying less for businesses in 2008-2010 than in 2005-2007.

Best of times………..

Have we found the bottom and will things start to improve? Well, a few “stars” appear to be aligning:

·         The national economy has shown signs of improvement and most of the “experts” seem to think we will experience moderate growth through 2010.

·         Banks appear to be, cautiously, loosening up a bit and the Small Business Administration is providing some incentives for banks to lend.

·         All those Private and Publicly traded companies, Private Equity Groups and  Venture Capitalists that have been stockpiling cash have started to edge back in to the M&A market to take advantage of lower pricing multiples and “cherry pick” attractive firms.

There are, of course, risks to the continuation of these positive trends and when things will actually take off at a more robust pace is the subject of considerable debate.

However, some of these factors are less dependent on specific economic conditions. Private Equity and Venture Capitalists typically pool the money of High Net Worth individuals and invest that money in privately held businesses with specific industry and return requirements. Many have been sitting on the sidelines, with much of their money available for investment earning 0.5% in a money market account for the past few years. Their investors are certainly not happy with that rate of return and expect things to change as soon as possible. Also, demand from international buyers, especially China and India, looking to enter the US Markets see M&A as a quick and efficient way to establish a presence.

Privately held firms do not have access to the capital markets, such as the NYSE or the NASDQ, where their publicly owned big brothers can generate almost unlimited capital at much lower costs than the private sector, which depend on banks to finance acquisitions. Therefore, the availability of capital in the form of senior bank debt is, perhaps, the single most important factor that impacts the under $50M M&A marketplace.  Without this key source of capital, along with junior debt like owner financing or mezzanine debt, deals just don’t happen in this arena. Hopefully, incentives like SBA loan guarantee programs along with other positive industry trends will result in more readily available senior debt financing for M&A.

One factor that has not been addressed is the specific facts and circumstances surrounding your particular enterprise. To be clear, companies with positive growth trends, predictable cash flows and solid value propositions are less dependent on the variables listed previously. The statistics presented in the deal chart are median values, which means, some businesses sell higher than the numbers cited. Of course, businesses on the other side of the spectrum may sell below those multiples. In all cases, setting a realistic sales price is the key to a successful transfer within a reasonable amount of time.

This article assumes you, the owner, have the luxury of deciding if and when you will be exiting your business. Some are not so fortunate, and must sell in the short term due to health, marital or a myriad of other personal and business issues that confront them.  When to begin the process of selling your business is fraught with uncertainty but, that risk can be mitigated by readying your business for sale as soon as possible. Owners need to understand that it is virtually impossible to list, sell and close the sale of your business in 3 months. In order to maximize value, a 12-18 month time frame is more typical. Starting the process now, will position you to take advantage of the expected return to more normal pricing multiples, increased availability of bank financing and increased demand for realistically priced firms. If that expected recovery does not materialize for a time, your enterprise is still more advantageously positioned to capitalize when the M&A “stars” finally align.

Cliff Olin, CM&AA, CEPA and principal at Olin Capital Advisors, a small to mid market, mergers and acquisitions advisory and exit planning firm. He can be reached at colin@olincapital.com.