Recently in Valuation Category

Do you agree with the claim we have too many restaurants -- and the evidence in this article?

Are we due for a shakeout -- because it has been so long in coming, have people in the industry forgotten what it will be like?

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Recently, we've been talking about the different types of buyers we work with and how the buyer market has changed during the past few years; some good and some "to be determined".

In this article, we talk about the private equity group (aka PEG) of buyers and what that means to sellers of smaller privately owned businesses like yours.

There's been a lot of news recently about PEGs, mostly in a political and tax related context (e.g., Mitt Romney's success as a partner with Bain Capital and the income tax rate he pays). We'll stay away from that. That's a whole other discussion!

What is a PEG?

They've been around since the 70s starting as larger, "mega" buyout firms (Bain, etc.)

They are investors who have private funds (a combination of personal funds and investor funds) to invest and are seeking alternative investment opportunities (i.e., privately owned businesses) where financial returns can "beat the market"

They buy companies across all industries and usually want a 100% ownership, or at least a majority ownership (51%) in the companies they buy.

They typically buy mature, established companies - not early-stage or startup businesses.

The goal of the PEG is to improve and grow the company with a goal to "exit" their investment in the next 5-10 years, at which time they return the gains to their investors and "close the fund".

What's this mean to you?

Here's the change that's going on. In the last 3 years, we've talked with numerous nationally based PEGs who are investing in smaller privately owned businesses. A typical investment opportunity is a company with:

• gross revenues of $2-$20M
• a stable management team
• a growing industry and
• an opportunity to either grow or combine a new opportunity with a similar business they already own.

Specifically, the PEGs we've talked to and met with are interested in businesses we represent in the following markets:

• Health care services
• Distribution
• Food Service.

If you are considering selling your business, especially in one of these industries, we believe that, in the right circumstances, PEGs are a legitimate pool of potential buyers that should be considered.

As we've pointed out, the buyer pool is constantly changing and much more diverse than it was 3 years ago.

Today's business seller needs to be more aware than ever of how the pool is changing and what impact this has on potential sales opportunities.

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When a C-corporation sells an asset and the corporation's owner goes to work for the buyer, there may be an incentive for the parties to pay the owner a higher salary than the market will bear, as disguised payments for the asset. That's because the purchaser can currently deduct salary, but must capitalize any purchase payments.

At the same time, there may be a trap: if the payments are found to be in substance purchase payments to the selling C-corporation, the payments will face double taxation, once at the corporate level and again upon distribution as dividends.

In H&M, Inc. v. Commissioner, T.C. Memo 2012-290 (October 15, 2012), H&M, Inc. agreed to sell its insurance business to a local bank and competitor. Under the purchase agreement, H&M agreed to sell "all files, customer lists, insurance agency or brokerage contracts, the name of [the insurance business], and all the goodwill of [the insurance business]" for $20,000.

The deal was contingent upon the agreement by H&M's owner - Mr. Schmeets - to work for the buyer for six-years and also enter into a covenant not-to-compete for a period of 15 years. Under these latter agreements, Schmeets would receive over $600,000 during the six years. The agreement was later modified, so that some of the compensation would be deferred, would earn interest, and would be payable to Schmeets' estate in the event that Schmeets died.

The Court found that there had been no appraisal of H&M's assets prior to entering into the agreement. In fact, the buyer didn't even examine H&M's financial records. In addition, prior to the sale, H&M had paid Schmeets a salary of about $29,000 per year.

The IRS argued that Schmeets' wages were actually disguised payments to H&M for the sale of the business and urged the Court to apply the "substance-over-form doctrine" to recharacterize the transaction.

While lamenting the parties' failure to adequately document the transaction, the Tax Court rejected the IRS' position. To demonstrate that the business was worth more than $20,000, the IRS would need to show that the assets were undervalued. But the only intangible that the IRS pointed to as being undervalued was the goodwill of the business.

Generally, there is no salable goodwill where the business depends upon the personal relationships of a key individual, unless there is an agreement that prevents that individual from taking his relationships, reputation and skills elsewhere.

Here, "there was convincing testimony that . . . . no one knew insurance better than Schmeets." Furthermore, Schmeets had no agreement with H&M (of which he was the sole owner, incidentally) that would have prevented him from going to work elsewhere. Thus, the business' goodwill had no value.

The Court also gave "no weight" to the opinion of the IRS' expert, who opined that Schmeets' new salary was excessive, since the expert ignored Schmeets' particular skills and level of experience.

Finally, the Court noted that, in negotiating the sale and related agreements, there was "virtually no discussion" about the tax consequences of the transaction.

The employment relationship was motivated by Schmeets' desire for guaranteed employment and the buyer's desire to harness his skills, not for "massaging the paperwork for its tax consequences."

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In the franchise finance world, the most discussed number is the EBITDA--EBBADABADOO as some call it. EBITDA is earnings before interest, taxes, depreciation and amortization. It is really a sub-total to the income statement. It is earnings without any charges for cost of funds, taxes or capital spending.

EBITDA's use began popularized as a credit metric, used in the 1980s M&A and credit analysis world--to test for adequacy of debt coverage. EBITDA is often the common denominator to track and report company buyout values:  the acquisition enterprise value to EBITDA ratio is a very commonly reported metric. So much so that that's where the focus goes. And its use as a simple business valuation tool: the company is worth some multiple of EBITDA; the higher the multiple, the higher the price, and vice versa.

In the franchising space, where franchisors might report a simple EBITDA payback for an investment, or report EBITDA value in their franchise disclosure document item 19 section. The special problem there is this EBITDA is stated in terms of the restaurant level profit only--before overhead. Really, the problem is this: EBITDA doesn't show the whole picture. It is a sub-total. It doesn't show full costing.

EBITDA alone as the metric misses at least eight costs and expenses, that are vital to know, calculate and consider in operating and valuing the business as a cash and value producer.  Using a business segment such as a store, restaurant or hotel as an example, here are the eight required reductions to EBITDA that must be subtracted, listed in order of magnitude of the cash outlay, to really get to operating economic profit.

1. Interest expense:  the cost of the debt must be calculated. Interest is amount borrowed times the interest rate times the number of years. One can have rising EBITDA but still go broke.
2. Principal repayment:  the business cash flow itself should contribute to the ability to pay back the principal debt. That often is in a 5 or 7 year maturity note and is another very large cost that must be considered.
3. Future year's major renovation/remodeling: once the storefront is built, it has to be renewed and refreshed in a regular cycle, often every 5-10 years, via capital expenditures (CAPEX). That often is 10-30% of the total initial investment, or more, over time.
4. Taxes, both state and federal: Financial analysis often is done on a pre-tax basis as there are so many complicating factors. But the reality is the marginal tax rate is about 40%.
5. New technology and business mandates: aside from the existing storefront that must be maintained, new technology, and new business innovation CAPEX must be funded to remain competitive. Example: new POS systems for restaurants, new technology for hotels.
6. Overhead: if the EBITDA value is stated in terms of a business sub-component, like a store, or restaurant or hotel, some level of overhead contribution must be covered by the EBITDA actually generated. Generally, there are no cash registers in the back office, and it is a cost center.
7. Maintenance CAPEX: for customer facing businesses (retailers, restaurants, hotels, especially) some renovation of the customer and storefronts must occur every year and does not appear in the EBITDA calculations.  New carpets, broken windows, you get the idea. In the restaurant space, a good number might be 2% of sales.
8. And finally, new expansion must be covered by the EBITDA generation, to some level. New store development is often a requirement in franchise agreements, and new market development necessary. While new funds can be borrowed or inserted, the existing business must generate some new money for the expansion.

You might say...these other costs and expenses are common sense, they should show up in the detailed cash flow models that should be constructed. Or they can be pro-rata allocated. But how times does this really happen? The EBITDA metric becomes like the book title....or the bumper sticker that gets placed on the car. You really do have to read further or look under the hood. And the saying is true...whatever you think you see in EBITDA...you need more.