The pitfalls of hiring a dual agent in a business sale transaction
Most people have heard of dual agency in the context of a real estate transaction and have some awareness of the issues surrounding dual agency. In spite of the inherent conflict of interest, many people do not mind transacting residential or commercial property using a dual agent. The reason is pretty straight forward – while there is risk of not getting good representation, the downside is typically small. Property values are driven by comps and cap rates and in most cases, the amount of money left on the table is a small percent of the transaction value. The commodity nature and relative liquidity of real estate also helps make buyers and sellers comfortable with the risk level.
But does this logic apply to business sale transactions? Businesses, compared to real estate, are illiquid and the valuations and the ultimate closing prices vary dramatically from business to business. The deal amount can also change dramatically through the duration of a deal. In Business sale transactions, not having a fiduciary agent working for you can cost you plenty.
Let us start with an explanation of “fiduciary duty”. An agent used to represent a buyer or seller in a business transaction has a fiduciary duty. A fiduciary duty is the highest standard of care imposed at either equity or law. A fiduciary is expected to be extremely loyal to the principal. Among other responsibilities, a fiduciary must not put their personal interests before the duty and a fiduciary must not profit from the fiduciary position without express knowledge and consent of the principal. A fiduciary also has a duty to be in a situation where there is no personal conflict of interest and where there is no conflict of interest with another fiduciary duty.
In light of large sums of money at stake in a business transaction and these fiduciary responsibilities, let’s look at the three key issues faced by a dual agent in a business sale.
1. Conflict of Interest
This is by far the most obvious and most damning part of being on both sides of a business sale transaction. A business intermediary is obligated to serve the best interests of his or her principal. Buyers and sellers by definition have conflicting interests. Who should the intermediary be loyal to? Is the agent looking after your best interests? Some agencies will tell customers that they will assign separate individuals to the buying side and selling side and create a Chinese wall.
In practice, the wall between the two sides in the same company, even in a large company with processes to cover this type of conflict of interest, let alone a typical small to mid market intermediary, is more akin to a sieve than Chinese wall. An agency in this situation is in violation of the standards of being a fiduciary.
2. Advocacy
Any competent agent will tell you that, when two principles’ interests are in direct conflict, the agent cannot advise, advocate, or give allegiance to either party if such counsel gives one party an advantage over the other. Not remaining neutral or showing favoritism would be illegal and can make the agent liable to potential damages. A careful dual agent would shun the risk of advocacy and will tell you that they will be extremely careful to represent both parties equally and fairly. In other words, both parties lose "advocacy" for their best interests! Is this what you pay your agent for? Wouldn’t you rather pay an agent that advocates your interests?
In practice, providing equal service to two parties is difficult and, even if the agent is highly ethical, agent’s biases and self interests may tip the scales in difficult situations.
3. Sensitive Information
A business sale can take an extended amount of time and the seller or buyer may experience one or more personal events which, while not affecting the performance of the business being transacted, may have substantial impact on the negotiations. The agent may become aware of this sensitive information which, if disclosed to the other party, could harm one party and benefit the other. If the agent has one principal, clearly the agent will develop a strategy to minimize the impact to the principal. How does a dual agent handle this type of information about a client? Would you trust your sensitive information with a dual agent?
In practice, the agent ends up playing favorites or in a worst case scenario, one or both of the parties’ interests are sacrificed in the interest of “getting the deal done”.
Summary: Business sellers and buyers need to carefully pick their agent in a business sale transaction. Providing equal service to both clients is practically impossible in most deals. In the best case scenario, neither the seller nor the buyer is getting an advocate. In the worst case scenario, one or both of the parties are being sacrificed. For this reason some states do not permit dual agency. Much can be lost by employing agents who put themselves in the position of being dual agents and thus not living up to the fiduciary standards.
For most business owners, a business sale is a once in a lifetime event with significant impact on how well the family’s nest egg is feathered. With so much at stake, can you afford to employ a dual agent?
Saturday, February 23, 2008
Wednesday, February 20, 2008
The Limitations of Using EBITDA for Mid Market Companies
Looking behind the numbers
"Does management think the tooth fairy pays for capital expenditures?" – Warren Buffett
EBITDA, follow-on to EBIT, was created by investment bankers to find out the true operating profitability of the company. EBITDA is a great tool to measure the profitability of companies with expensive assets that get depreciated over an extended period of time. Financiers look at EBITDA to measure the debt carrying capacity of the company. It is common to measure mid-market company profitability and cash flow using EBITDA and use EBITDA as the exclusive indicator of the business performance.
Each business has its own unique set of strengths, weaknesses, opportunities and threats, none of which can be captured by EBITDA or any other single metric. Intelligent business acquirers must consider the amount, the growth rate, and the variability of cash flow generated by the operations. EBITDA, when used properly, can be a helpful starting point in this regard. However, as you will see from the discussion below, EBITDA has several limitations when it is used for measuring cash flow.
To arrive at EBITDA for a business, acquirers add back Interest, Taxes, Depreciation, and Amortization to the Net Income of the company. Let’s look at each of the items in EBITDA to understand the rationale and limitation of these add backs:
* Earnings
The most common mistake seen in EBITDA calculations is the inclusion of non-operational earnings in the earnings number. To start off the process, it is imperative that all non operating profits have been factored out of the earnings. Are one time real estate or other asset sales factored into the earnings calculations? How about warranty cost reserves and bad debt allowances? The earnings data needs to be scrubbed to make sure that the earnings number used in EBITDA reflects operating earnings.
* Interest
Interest payments of a business are primarily a function of the company’s financing strategy and vary widely depending on the debt to equity ratio preferred by the ownership. The resulting leverage factor can artificially inflate or deflate the net income. While adding back interest makes sense in terms of identifying operating profitability, it does not make sense to add interest back in terms of cash flow. Interest payments are certainly a burden on the cash flow! To get a more meaningful measure of cash flow, it would be necessary to subtract from EBITDA the anticipated cost of financing under the new regime.
* Taxes
Taxes are accounting and owner dependent and a pre tax view of the profits would be a better indicator of the operating profit stream. However, like interest payments, taxes are a real expense and estimated taxes under the new financing and operational structure should be factored into calculating the expected cash flow.
* Depreciation
Depreciation is an accounting construct that provides for an indirect and backward looking measure of capital expenses. Depreciation expense can be a highly misleading indicator. The accounting treatment of depreciation for many businesses is substantially different from real world depreciation. For equipment intensive businesses, adjustments to EBITDA are almost always necessary to get a true picture of the earnings.
Since depreciation is a non cash expense, it makes sense to add the line item back for cash flow calculations. However, keep in mind that some of the depreciated items need to be replaced over time and new equipment needs to be added in. Any cash flow calculation should factor in the cost of the replacement equipment.
* Amortization
Amortization is similar to depreciation except that what is being depreciated are intangible assets such as goodwill of the business – very likely from a past acquisition or startup costs. Barring a few rare exceptions, amortization can be fully added back for profitability and cash flow calculations.
In addition to the above, there are some other limitations to EBITDA. It is important to understand that EBITDA only accounts for two non-cash items - Depreciation and Amortization. There is no provision in EBITDA to adjust for some very important non-cash items such as stock grants, stock option grants, inventory value adjustments, bad debt allowances, and gift certificate redemption credits.
EBITDA also ignores the impact of changes in working capital. Increases in working capital consume cash and a business could have great EBITDA numbers but terrible cash flow numbers and could be on the verge of going out of business. To have a meaningful picture of the cash flow, acquirers need to review working capital changes to see if there are growth related issues or other working capital changes of significance and adjust cash flows accordingly.
In summary, acquirers should not rely exclusively on EBITDA or any other single metric to measure the performance of a business. To the extent EBITDA is used, acquirers should replace the removed interest, taxes, depreciation, and amortization from their earnings calculations with their own expected operating numbers to get a better picture of anticipated profitability and cash flow and the variability to the cash flow. This can be accomplished by:
- Substituting the Interest costs with expected capital costs under the anticipated capital structure
- Substituting the Tax items with their own tax-rate calculations under the new capital structure.
- Substituting Depreciation expense with an estimate of future capital expenditures.
- Amortization can be kept at zero unless there are extraordinary items that need to be factored in.
- Reviewing working capital changes and adjusting cash flows accordingly.
"Does management think the tooth fairy pays for capital expenditures?" – Warren Buffett
EBITDA, follow-on to EBIT, was created by investment bankers to find out the true operating profitability of the company. EBITDA is a great tool to measure the profitability of companies with expensive assets that get depreciated over an extended period of time. Financiers look at EBITDA to measure the debt carrying capacity of the company. It is common to measure mid-market company profitability and cash flow using EBITDA and use EBITDA as the exclusive indicator of the business performance.
Each business has its own unique set of strengths, weaknesses, opportunities and threats, none of which can be captured by EBITDA or any other single metric. Intelligent business acquirers must consider the amount, the growth rate, and the variability of cash flow generated by the operations. EBITDA, when used properly, can be a helpful starting point in this regard. However, as you will see from the discussion below, EBITDA has several limitations when it is used for measuring cash flow.
To arrive at EBITDA for a business, acquirers add back Interest, Taxes, Depreciation, and Amortization to the Net Income of the company. Let’s look at each of the items in EBITDA to understand the rationale and limitation of these add backs:
* Earnings
The most common mistake seen in EBITDA calculations is the inclusion of non-operational earnings in the earnings number. To start off the process, it is imperative that all non operating profits have been factored out of the earnings. Are one time real estate or other asset sales factored into the earnings calculations? How about warranty cost reserves and bad debt allowances? The earnings data needs to be scrubbed to make sure that the earnings number used in EBITDA reflects operating earnings.
* Interest
Interest payments of a business are primarily a function of the company’s financing strategy and vary widely depending on the debt to equity ratio preferred by the ownership. The resulting leverage factor can artificially inflate or deflate the net income. While adding back interest makes sense in terms of identifying operating profitability, it does not make sense to add interest back in terms of cash flow. Interest payments are certainly a burden on the cash flow! To get a more meaningful measure of cash flow, it would be necessary to subtract from EBITDA the anticipated cost of financing under the new regime.
* Taxes
Taxes are accounting and owner dependent and a pre tax view of the profits would be a better indicator of the operating profit stream. However, like interest payments, taxes are a real expense and estimated taxes under the new financing and operational structure should be factored into calculating the expected cash flow.
* Depreciation
Depreciation is an accounting construct that provides for an indirect and backward looking measure of capital expenses. Depreciation expense can be a highly misleading indicator. The accounting treatment of depreciation for many businesses is substantially different from real world depreciation. For equipment intensive businesses, adjustments to EBITDA are almost always necessary to get a true picture of the earnings.
Since depreciation is a non cash expense, it makes sense to add the line item back for cash flow calculations. However, keep in mind that some of the depreciated items need to be replaced over time and new equipment needs to be added in. Any cash flow calculation should factor in the cost of the replacement equipment.
* Amortization
Amortization is similar to depreciation except that what is being depreciated are intangible assets such as goodwill of the business – very likely from a past acquisition or startup costs. Barring a few rare exceptions, amortization can be fully added back for profitability and cash flow calculations.
In addition to the above, there are some other limitations to EBITDA. It is important to understand that EBITDA only accounts for two non-cash items - Depreciation and Amortization. There is no provision in EBITDA to adjust for some very important non-cash items such as stock grants, stock option grants, inventory value adjustments, bad debt allowances, and gift certificate redemption credits.
EBITDA also ignores the impact of changes in working capital. Increases in working capital consume cash and a business could have great EBITDA numbers but terrible cash flow numbers and could be on the verge of going out of business. To have a meaningful picture of the cash flow, acquirers need to review working capital changes to see if there are growth related issues or other working capital changes of significance and adjust cash flows accordingly.
In summary, acquirers should not rely exclusively on EBITDA or any other single metric to measure the performance of a business. To the extent EBITDA is used, acquirers should replace the removed interest, taxes, depreciation, and amortization from their earnings calculations with their own expected operating numbers to get a better picture of anticipated profitability and cash flow and the variability to the cash flow. This can be accomplished by:
- Substituting the Interest costs with expected capital costs under the anticipated capital structure
- Substituting the Tax items with their own tax-rate calculations under the new capital structure.
- Substituting Depreciation expense with an estimate of future capital expenditures.
- Amortization can be kept at zero unless there are extraordinary items that need to be factored in.
- Reviewing working capital changes and adjusting cash flows accordingly.
Tuesday, February 05, 2008
Net Income, EBIT, EBITDA, SDCF
What is the right metric to use for business valuation?
The most commonly used “earnings figures” used for small to mid-market business valuation are Net income (NI), Earnings Before Interest and Taxes (EBIT), Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and Seller’s Discretionary Cash Flow (SDCF). With a variety of metrics to choose from it is natural for a business owner to ask “which is the right one to use for my business”. To answer the question, first we need a quick background on what these earnings metrics are.
* NI: NI is the net profit of the business after deducting all expenses of the business including all operational expenses, owners’ or officers’ salary, interest expense, taxes, etc. Some people consider this as the “true earnings” but for many small to mid market companies, which are on a constant quest to minimize taxes, this number can be grossly understated and is not a true reflection of the company’s earnings stream.
* EBIT: EBIT is the net profit of the business before factoring in financing and taxes. The rationale for using this metric is that tax payments are highly accounting and owner dependent and a pre tax view of the profits would be a better indicator of the profit stream. Similarly, interest payments that are a function of the company’s financing strategy and vary widely depending on the debt to equity ratio preferred by the ownership. The resulting leverage factor can artificially inflate or deflate the NI. EBIT shows an earnings number that is adjusted for these variables to reflect a truer picture of the earnings.
* EBITDA: The accounting treatment of Depreciation and Amortization for many businesses is substantially different from the real cash flow impact these elements have on the business. EBITDA allows for looking at the profitability of the business before factoring in these two items. One needs to be aware that this can be a highly misleading indicator based on the depreciation and amortization characteristics of the business and adjustments to EBITDA are almost always necessary to get a true picture of the earnings.
* SDCF: For smaller businesses, where the owner may see the business as a “job”, the true measure of profitability may be the sum of all the monies the owner derives from the business including salary, benefits and other perks.
Effectively,
* EBIT = Net Income + Interest + Taxes
* EBITDA = EBIT + Depreciation + Amortization
* SDCF = EBITDA + Owner/Officer’s Salary + Benefits + Perks
So, the answer to the question, “Which earnings is the right one for my business?” depends on the nature and size of a business and an understanding of which metric may more accurately reflect the true earnings. For many mid-market businesses the appropriate metric is likely to be EBIT or EBITDA.
Once the correct metric is identified, the business owner needs to understand the range of multiples that may be applicable to the chosen metric. For example, the earnings multiples for most small companies tend to vary between 1 to 3 times SDCF and the earnings multiple for mid-market companies are more likely to be 3 to 5 times EBIT or 3 to 7 times EBITDA.
However, businesses tend to be more unique than typical and a multiple that is good for one business may be too low or too high for another. The more exceptional the business is, the more likely it is that the multiplier will be outside of the typical range.
The most commonly used “earnings figures” used for small to mid-market business valuation are Net income (NI), Earnings Before Interest and Taxes (EBIT), Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and Seller’s Discretionary Cash Flow (SDCF). With a variety of metrics to choose from it is natural for a business owner to ask “which is the right one to use for my business”. To answer the question, first we need a quick background on what these earnings metrics are.
* NI: NI is the net profit of the business after deducting all expenses of the business including all operational expenses, owners’ or officers’ salary, interest expense, taxes, etc. Some people consider this as the “true earnings” but for many small to mid market companies, which are on a constant quest to minimize taxes, this number can be grossly understated and is not a true reflection of the company’s earnings stream.
* EBIT: EBIT is the net profit of the business before factoring in financing and taxes. The rationale for using this metric is that tax payments are highly accounting and owner dependent and a pre tax view of the profits would be a better indicator of the profit stream. Similarly, interest payments that are a function of the company’s financing strategy and vary widely depending on the debt to equity ratio preferred by the ownership. The resulting leverage factor can artificially inflate or deflate the NI. EBIT shows an earnings number that is adjusted for these variables to reflect a truer picture of the earnings.
* EBITDA: The accounting treatment of Depreciation and Amortization for many businesses is substantially different from the real cash flow impact these elements have on the business. EBITDA allows for looking at the profitability of the business before factoring in these two items. One needs to be aware that this can be a highly misleading indicator based on the depreciation and amortization characteristics of the business and adjustments to EBITDA are almost always necessary to get a true picture of the earnings.
* SDCF: For smaller businesses, where the owner may see the business as a “job”, the true measure of profitability may be the sum of all the monies the owner derives from the business including salary, benefits and other perks.
Effectively,
* EBIT = Net Income + Interest + Taxes
* EBITDA = EBIT + Depreciation + Amortization
* SDCF = EBITDA + Owner/Officer’s Salary + Benefits + Perks
So, the answer to the question, “Which earnings is the right one for my business?” depends on the nature and size of a business and an understanding of which metric may more accurately reflect the true earnings. For many mid-market businesses the appropriate metric is likely to be EBIT or EBITDA.
Once the correct metric is identified, the business owner needs to understand the range of multiples that may be applicable to the chosen metric. For example, the earnings multiples for most small companies tend to vary between 1 to 3 times SDCF and the earnings multiple for mid-market companies are more likely to be 3 to 5 times EBIT or 3 to 7 times EBITDA.
However, businesses tend to be more unique than typical and a multiple that is good for one business may be too low or too high for another. The more exceptional the business is, the more likely it is that the multiplier will be outside of the typical range.
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