Throughout my career as a middle market M&A advisor, I have had the opportunity to work with a number of manufacturing business owners looking to sell their companies. They will often lead with the strength of the company’s balance sheet when discussing its potential value in a transaction, focusing the conversation on the company’s assets (including inventory), working capital, equipment, and the company’s lack of debt. These are the places where the company has usually invested a lot of money, so it naturally seems like the best way to define the company’s value. Unfortunately, as I am quick to tell them, this is a common yet incorrect assumption.
Ultimately, potential buyers care about the investment, income and the relationships between the two. While the assets inside a company are important, they are important because and to the extent that they help generate income.”
Let’s look at two examples:
Company A generates $10 million/year in earnings before interest, taxes, depreciation and amortization (EBITDA) in an asset-light business with customers that pay at the time of service. The company has $500,000 in assets and can operate on $0 working capital because of the timeliness of payments.
In contrast, Company B, which also generates $10 million/year in EBITDA, is in a capital-intensive heavy industry. The company has $100 million in assets and requires an additional $15 million in working capital to finance its inventory and its slow-paying customers.
Which company is worth more?
The companies have relatively equivalent values (although you could make a credible argument that the asset-light business is worth more because the capital-intensive business will require capital expenditures over time that will serve to reduce cash flow from the business). Looking at the companies from an input/output perspective, we see that they are the same. A buyer will need to input a purchase price to generate $10 million in output income.
What about all of the assets in Company B? While this is greatly oversimplified, they don’t add value. Company A and Company B both derive their value from their income, not from their assets. The buyer doesn’t care what will generate the output.
Streamlining your business
Once you understand that your company’s value doesn’t come from the assets inside it, the path forward becomes much clearer: streamline the business. Since a buyer will largely not pay for the assets within, remove as many of them as you can.
There are a variety of ways that companies preparing for a transaction can whittle down their balance sheets:
1. Equipment: Companies can often simply maintain too much equipment on the books. If there is an opportunity to right-size the company’s equipment stock prior to a sale, this can be a good chance to generate additional value. Selling lightly used equipment can generate cash without significantly impacting the generation of revenue.
2. Inventory: Similarly, holding too much inventory can be a cash sink. There is a reason that many companies have gone to just in time (JIT) production strategies. Consider evaluating your company’s raw material and product inventory to determine if either can be reduced.
3. Accounts Receivable: While easier said than done, reviewing your accounts receivable and encouraging shorter pay periods can be helpful in reducing working capital needs.
4. Accounts Payable: Similarly, extending accounts payable can similarly reduce working capital needs.
5. Outsourcing: Finally, there are often activities within the company that require working capital and/or are capital-intensive that don’t necessarily drive a lot of profit to the bottom line. Consider whether outsourcing these sorts of activities can squeeze the balance sheet without significantly affecting the bottom line.
Streamlining your business is a great way to both generate cash savings in the short term and increase the overall value to you of a transaction by allowing you to keep the value you generate in the streamlining.
However, like so many opportunities for improving the value of your company in advance of a sale, streamlining your company is something that you need to do over time. Because a buyer will rightfully want to know whether changes that have been made are sustainable, these sorts of operational and balance sheet changes need to be made well in advance of any transaction so that a period of steady operations can be shown downstream of the changes.
Michael Schwerdtfeger is a sell-side mergers and acquisitions advisor to middle market businesses and managing director at Chapman Associates. His free eBook “The Inner Workings of a Deal: Tips for a Successful Transaction” is now available for download on his website: http://mbsmergers.com/downloads/