What Do Those Business Terms Mean?

Also Known As:

BMVA, Estimate of Value, Business Valuation

IRS Revenue Ruling 59-60 determines the basis of fair market value. It states that fair market value is, “The amount at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having a reasonable knowledge of relevant facts.”

A calculation estimating how much money someone is likely to pay for your company.

For many business owners, your business is your largest retirement asset. Getting a periodic valuation allows you to have accurate information to plan for retirement. It also allows you to identify areas for streamlining, cost reduction, and to reevaluate your business operations.

EBITDA is a proxy for free cash flow.  It adds back the non-cash expenses (depreciation and amortization) as well as the interest and taxes that are a consequence of management decisions. Not every management team would deploy the same capital structures, so these expenses are added back in the calculation.

A tool to evaluate a company’s performance without factoring in finance, accounting, or tax decisions.

This tool is used to help you, the business owner, make accurate comparisons between companies.

A seller’s discretionary earnings are the pretax and pre-interest profits before non-cash expenses, one owner’s benefits, one-time investments, and any non-related income or costs.

All of the cash at the “bottom line” of your financial statement is available to the business owner.

This tool is used to help you, the business owner, make accurate comparisons between companies.

Also Known As:

LOI

This is the initial offer a buyer submits to a seller.  It lays out:

  • general terms of the purchase,
  • business value/purchase price,
  • real estate plan (if selling RE) purchase/value, structure,
  • source and use of funds,
  • working capital PEG,
  • seller considerations,
  • transition timing,
  • employment agreement,
  • non-compete,
  • indemnity cap and basket and
  • due diligence expectations.

These are initial offers to buy your business. Once you sign an LOI you exclusively work with this buyer towards closing the deal.

Each interested buyer submits an LOI. You compare these letters directly to evaluate their offer. It allows you to prioritize what is most important to you and find a buyer that matches your needs.

Also Known As:

IOI

Presented by a buyer before the LOI, indicating they are interested in pursuing the business further.  Documents include:

  • range of anticipated valuation,
  • a rough outline of the anticipated structure,
  • expectation of timeline from LOI acceptance to close, and
  • sources and uses of funds.

Site visits happen after IOIs are submitted.  This visit is for a small number of buyer groups.  Most sellers do not want to parade buyers through their facilities, interrupting their workforce.  We have had buyers pretend to be bankers, insurance agents, etc. to not alert the employees to the pending sale.

IOIs give a good indication of how many buyers are in the pool and where the initial offers stand.  Does the advisor need to continue looking, or are we confident we have our buyer?

The significant non-production cost presented in an income statement (statement of profit or loss).

All of the expenses on the profit and loss statement that are not directly tied to the cost of creating the product or service.

Business owners need to be aware that the SG&A is a potential topic of conversation for a buyer who wants to purchase your company and has duplicate services such as HR or payroll.

Also Known As:

LMM

The Lower Middle Market is the lower end of the middle market segment of the economy, as measured in terms of the annual revenue of the firms. Firms with an annual revenue in the range of $5 million to $50 million are grouped under the lower middle market category.

Companies in the LMM have grown beyond the Main Street Market. They are above $5M in revenue and have multiple employees, systems, and processes.

As a business owner, its less about what “market” your business falls into. The information is useful because understanding this jargon is important when working with advisors.

Also Known As:

Mom and Pop Business

Main Street is the smallest segment of the business economy.  It is measured in terms of the annual revenue of the companies.  Companies with annual revenue of less than $5 million

Examples:

  • Bars,
  • Restaurants,
  • Dry Cleaners, and
  • Hair Salons.

The buyer pool is much different when you are in the main street market.  You are generally looking for someone who is “buying a job.”  They are less sophisticated buyers.  The “shotgun” approach is used to attempt to reach as many buyers as possible instead of creating a targeted buyers list.

The Altman Z-Score is the output of a credit-strength test that helps gauge the likelihood of bankruptcy for a publicly-traded company.  The Z-score has five key financial ratios that can be found and calculated from a company’s annual 10K report.

This is a score that gauges the likelihood that a company might become bankrupt.

This is a useful metric for a company to review. Should the company be in a financial grey area or headed for bankruptcy, it is a great time to sit down with your trusted advisors and create a plan to turn the financials around moving in the right direction.

Also Known As:

WC

This ratio reflects the ability to finance current operations and is a measure of the margin of protection for current creditors. This ratio also indicates how efficiently working capital is being used. A low ratio (close to zero) may indicate inefficient use of working capital. A high ratio (high positive or high negative) often signifies overtrading, creating a vulnerable position for creditors.

The capital of a business which is used in its day-to-day trading operations, calculated as the current assets minus the current liabilities.

Working capital is a highly negotiated part of selling any business, and having a thorough understanding of your company’s WC needs and the industry norm before talking to buyers will help when negating the WC PEG.

Also Known As:

WC PEG

A benchmark or baseline amount of net working capital that is agreed upon by the buyer and the seller and is usually determined toward the end of financial due diligence.

The Working Capital PEG negotiated between the buyer and the seller.  It is the WC amount that will be left in the business as of the date of closing.

Once the WC PEG is set, there is a dollar for dollar adjustment at the time of closing for any difference.  If the actual WC is above the PEG on the day of closing, the seller will receive a “refund.”  If the actual WC is below the PEG, the seller will have to “pay in.”

Also Known As:

PEGs

PEG’s is an investment management company that provides financial backing and makes investments in the private equity of startup or operating companies through a variety of loosely affiliated investment strategies, including leveraged buyout, venture capital, and growth capital.

A group of investors who use other people’s money to purchase businesses.  They generally do not operate the business themselves but may insert management to run the business.  They typically hold the businesses for 5-7 years and then sell them for a higher return.

They are a potential buyer for your business.  They can look at your business in two different ways: as a platform or a bolt-on.

A platform company is a company that a Private equity group (PEG) views—when investing through acquisition in a new industry or market space—as a starting point for follow-on acquisitions in the same area.

This is the first investment a PEG makes in a certain industry or market. Depending on the PEG, the typical platform company has EBITDA of approximately $2M and must be scalable.

This is relevant to business owners when we start the buyer’s search. If the business is above $2M in EBITDA then we would approach PEGS in a way that would position the company as a potential platform acquisition.

Also Known As:

Add-On, Tuck-In

A bolt-on acquisition refers to a company that is added by a private equity (PE) firm to one of its platform companies, usually in the same line of business, that presents a strategic value.

This is a smaller investment for a PEG and could be of any revenue or EBITDA size, as long as it presents a synergistic value to the platform company.

For a smaller company, we would target PEGs that have an existing platform in the industry and perform research to show the potential synergies between the two companies.

A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt.  Its percentage of total capital weights the cost of each type of capital, and they are added together.

The purpose of WACC is to determine the cost of each part of the company’s capital structure based on the proportion of equity, debt, and preferred stock it has. Each component has a cost to the company. The company pays a fixed rate of interest on its debt and a fixed yield on its preferred stock. Even though a firm does not pay a fixed rate of return on common equity, it does often pay dividends in the form of cash to equity holders.

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.

It represents the minimum return the company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital.

The WACC calculates the Capitalization of Earnings and Discounted Cash Flow valuation methods.  Those methods are methods we have seen PEGs utilizing when evaluating the company to purchase.

The risk-free rate is the return that earns by investing in riskless security, e.g., U.S. Treasury bonds.

The risk-free interest rate is the rate of return of a hypothetical investment with no risk of financial loss over a given period.

This is used in calculating the WACC.

Also Known As:

ERP

Equity Risk Premium (ERP) is defined as the extra yield that can be earned over the risk-free rate by investing in the stock market.

The equity risk premium is based on the idea of the risk-reward tradeoff. As a forward-looking quantity, the equity-risk premium is theoretical. It cannot be known precisely since no one knows how a particular stock, a basket of stocks, or the stock market as a whole will perform in the future. It can be estimated as a backward-looking quantity by observing the stock market and government bond performance over a defined period. Estimates vary wildly depending on the time frame and method of calculation.

This is used in calculating the WACC.

Beta is a factor used to measure systematic risk. Systematic risk is the uncertainty of future returns owing to the sensitivity of the return on the subject investment to movements in the yields for a composite measure of marketable investments.

Beta refers to the volatility or riskiness of a stock relative to all other stocks in the market.

This is used in calculating the WACC.  Generally, we are using public company betas, since we are not able to calculate the company’s specific beta because the information is not available.

Also Known As:

Cap of Earnings

This method is used to value a business based on the future estimated benefits, normally using some measure of earnings or cash flows to be generated by the company. These estimated future benefits are then capitalized using an appropriate capitalization rate. This method assumes all of the assets, both tangible and intangible, are indistinguishable parts of the business and does not attempt to separate their values. In other words, the critical component of the value of the business is its ability to generate future earnings/cash flows. This method expresses a relationship between the following:

  • Estimated future benefits (earnings or cash flows)
  • Yield (required rate of return) on either equity or total invested capital (capitalization rate)
  • The estimated value of the business

Calculating the capitalization of earnings helps investors determine the potential risks and return of purchasing a company. However, the results of this calculation must be understood in light of the limitations of this method. It requires research and data about the business, which in turn, depending on the nature of the business, may require generalizations and assumptions. The more structure the business has, the more rigor applied to its accounting practices, the less impact any assumptions and generalizations may have.

This is another method of valuing a company. This is a more sophisticated approach than merely taking cash flow and multiplying it by a multiple to get the value. It involves significant research and knowledge of the type of business and industry.

Also Known As:

DCF

The income approach utilizing the Discounted Cash Flow Method is based on the theory that the total value of a business in the present value of its projected future earnings, plus the current value of the terminal value.  This method requires you to make a terminal-value assumption.  The amounts of projected earnings and the terminal value are then discounted to the present using an appropriate discount rate.  Solid financial projections are necessary for this method to produce an appropriate result.

This method says there is value in the future of your business. It will use your projected financial statements to assess the future value and then use an appropriate discount rate to discount that value to the present day.

This is another method of valuing a company. This is more sophisticated than taking cash flow and multiplying it by a multiple to get the value. You have worked hard to build your business. If you have a good growth story and reliable plans, this method makes sense to use.

This is a method we see PEGs using when evaluating companies to purchase.

The NAICS Code a standard used by Federal statistical agencies in classifying business establishments to collect, analyze, and publish statistical data related to the US Business Economy.

You must report your NAICS code on your business tax return. Your accountant probably does this for you.

All the benchmarking data we pull to value your business is based on the business NAICS code.

This is not pertinent for business owners, but it is useful information to have in mind when you meet with trusted advisors. Being familiar with business jargon will help you avoid feeling lost in the conversation.

A non-operating asset is a class of assets that are not essential to the ongoing operations of a business but may still generate income or provide a return on investment.

List these assets on a company’s balance sheet along with its operating assets, and they may or may not be broken out separately.

Examples:

  • Obsolete inventory
  • Personal vehicles on the asset list
  • Unused land

Having non-operating assets on your balance sheet skews your benchmarking data.  We can’t get an accurate comparison to the industry without removing those items first. Eliminating these items, you may find you are performing better!