Caveat Emptor

Determining what to pay for a company is a balance of art and science. On the art side, you’ll need vision, people skills, negotiation muscle and intuition. On the science side, you’ll tap finance, accounting, tax and general management skills.

When buying a company, it’s important to measure the deal in terms of free cash flow. Free cash flow is a measurement of profitability after expenses and reinvestments.

To gauge free cash flow, take the EBITDA (earnings before interest, taxes, depreciation and amortization), a proxy for cash flow that is available on your income statement, and subtract capital expenditures such as investments in property, plant or equipment.

The distinction between cash flow and free cash flow is important in capital-intensive businesses such as commercial printing, where it is common to see a 25% EBITDA margin shrink to 5% free cash flow, once the annual capital expenditures are factored in.

Free cash flow helps determine the acquisition candidate’s ability to weather market storms, fund existing operations, finance growth, service any debt incurred by the acquisition and generate the buyer’s desired shareholder returns. Healthy free cash flow is also an indication that customers value the company’s products or services.

Drivers of free cash flow can vary considerably by company. Conduct a sensitivity analysis, including worst-case scenarios for growth and profits, to determine how much free cash flow might sour if negative factors compound.

Warning: While the free-cash-flow method is widely lauded for its broad application, also consider other valuation methods (book, liquidation and replacement value). A low-priced business with poor cash flow may still be a "great buy" due to its liquidation value or hidden assets.

Paying for growth

Most middle-market valuations begin by determining the candidate’s past, present and projected free cash flows (usually three years back, three years forward). Yet free-cash-flow projections are only as good as their underlying assumptions. Company scale, market position, management acumen, customer breadth, intellectual property and competitive environment all influence your projections.

Expect to pay a premium for companies with excellent free-cash-flow growth prospects because it:

• Encourages owners to hold on.
• Decreases the time required to pay for a company.
• Suggests a winning market, scalable business model and strong management. More buyers like to buy winners.
• Leads to critical mass, which results in economies of scale, attracting superior management, allowing add-on deals and perhaps permitting an IPO.

The appropriate premium for strong growth is a case-by-case matter and must be weighted among other dynamics. If your quest is fast-growth companies, be sure you can handle (and finance) the tiger whose tail you try to grab.

Question all adjustments to free cash flow. Most private companies have "add-backs" (owner perks that will not be incurred after the sale, such as boats and "above norm" owner compensation), which should augment restated free cash flow.

Tip: Pay attention to one-time, nonrecurring adjustments. Are these truly gone for good, or are they really the norm for the candidate (as with R&D, capital expenditures, obsolete inventory and employee turnover)? It’s crucial to sweat the details. Every dollar of free cash flow will be multiplied by some factor to determine purchase price, so strive for accurate free-cash-flow numbers.

"We’ve looked at dozens of deals and completed six since 1999," according to Russell Stubbings, CEO of PAC Holding Co., a $40 million automotive and truck accessories company in Denver. "We pay particular attention to inventory. If our accountants can’t get comfortable with the value of that, it’s a clear warning of obsolescence. We’ve learned to heed our instinct in those matters and discount or walk away as appropriate."

Value synergies

Acquisitions are typically completed with some synergies in mind. Each party seeks to capture such benefits, but how much ends up in their pockets is a matter of negotiation.

Most sellers try to find buyers with synergies to capture right after the closing, says Jim Minarik, president and CEO of Directed Electronics Inc., a $140 million manufacturer of car security and convenience systems in Vista, Calif. Synergies can result from adding distribution, introducing outsourcing and buying better; however, Minarik prefers to pay for synergies when the seller’s management team continues with the company. "This becomes another way to reward them with the company’s future prosperity," he explains.

In some cases, the buyer’s synergies are so compelling that they can value an acquisition company beyond all others.

"Buying Booda out of Chapter 11 was a great opportunity," explains Robert Kirch, CEO of Aspen Pet Products Inc., a $60 million manufacturer of pet accessories in Denver. "The industry, brand positioning, customer base and product strategy all fit perfectly. We then identified near-term cost-cutting opportunities in operations and logistics, allowing us to value the company beyond the typical bankruptcy ‘bottom fishers.’

"Speed and price won us the founder’s and the bank’s overwhelming favor," Kirch says.

Calculating cost of capital

The cost of borrowing funds for an acquisition will be affected by your company’s size, stability and profitability; management quality; demonstrated expertise in acquisitions; pre- and post-close debt; size, stability/ risk and profitability of the acquisition; and relationships with lenders.

It’s critical to know your weighted average cost of capital (WACC) — the deal’s break-even point. Start by calculating your cost of debt (interest rate to borrow funds) and your company’s return on equity. Then weigh these calculations according to your debt-to-equity ratio.

For example, if your WACC is 15% and the deal price returns only 10%, you should negotiate lower or walk from the deal, unless there is a defensive reason to buy at a loss.

Tip: Inflate your WACC by several points. This provides you with a cushion.

The real magic in some transactions might be in the terms, not the price. The structure of your deal can make purchase dollars go 50% further (see chart).

Writer: Alexander G. Watson is president of Level Next Inc., a Petoskey, Mich.-based business-development adviser and acquisition intermediary. awatson@levelnextinc.com