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Creating Shareholder Value

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Creating shareholder value and advising buyers and sellers of privately held businesses

Creating shareholder value and advising buyers and sellers of privately held businesses

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  • Sometimes relatively small changes in product/service mix can have a substantial impact on results Need to know customer profitability
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    • 1. Creating Shareholder Value and Advising Buyers and Sellers of Privately Held Companies Presented by: W. James Lloyd, CPA/ABV, ASA, CFE 2009 Southeastern Accounting Show August 27, 2009
    • 2. Presentation Objectives
      • Creating Shareholder Value
        • Overview and key principles
        • Tools for measuring value
        • Looking for opportunities
        • Having a plan
        • Getting employees on board
      • Advising Sellers
      • Advising Buyers
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 3. Premise Number One
      • Privately-held companies are investments and should be managed as such
      • Generally represent a significant portion of the owners’ personal wealth
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 4. Premise Number Two
      • Valuation is a forward looking concept!
      • What happened in the past is in the past
      • Investors buy/sell future operations (cash flow)
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 5. Premise Number Three
      • Management’s primary function is to increase shareholder value
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 6. Creating Shareholder Value
      • Two key elements…….
        • Growing net cash flow available to the owners on a long-term sustainable basis
        • Earning a return on invested capital greater than the company’s cost of capital
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 7. Revenue Growth
      • Revenue growth is essential for increasing cash flow on a long-term sustainable basis
      • However….
      • Not all revenue is created equal!
      • New revenue must generate a ROIC > the company’s cost of capital
      • The impact of new product/service lines should
      • be evaluated carefully before proceeding.
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 8. Operating Expenses
      • Unnecessary operating expenses should be eliminated. However…..
        • There are obvious limitations on how much cash flow can be increased, on a long-term sustainable basis, by reducing operating expenses
      • Excessive reductions in operating expenses and/or reinvestments can actually have a negative impact on value
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 9. Return on Invested Capital
      • ROIC = NOPAT/total invested capital
      • Where:
        • NOPAT = net operating profit after taxes
        • Total invested capital = net working capital + fixed assets (or stockholders’ equity + debt)
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 10. ROIC Example
      • Assume:
        • NOPLAT = $500,000
        • Debt = $1,000,000
        • Equity = $2,000,000
      • ROIC = $500,000/($1,000,000+$2,000,000)
      • = 17%
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 11. Cost of Capital
      • Capital is comprised of two types:
        • Debt financing; and
        • Equity financing
      • Therefore, a company’s cost of capital is determined by its weighted average of cost of debt capital and equity capital
        • Generally referred to as its WACC
        • Weights should be based on market values
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 12. WACC as a Hurdle Rate
      • WACC should be viewed as a hurdle rate for decision making purposes
      • Returns in excess of the WACC increase value
      • Returns below the WACC decrease value
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 13. Calculating WACC
      • WACC = Dc x Wd + Ec x We
      • Where:
        • Dc = Cost of debt (net of tax benefits)
        • Wd = Percentage of capital structure funded by debt
        • Ec = Cost of equity
        • We = Percentage of capital structure funded by equity
        • Note : weightings should be based on market values not book values
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 14. Cost of Equity
      • Equity investments in privately-held companies have a cost
      • Cost of equity = the rate of return necessary to compensate the owners for investing their capital in the business
        • Note : the rate of return should be reflective of the risk of the investment.
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 15. Cost of Equity
      • Determining the cost of equity...
      • Generally use actual returns from alternative investment choices as proxies
      • Two most common methods for measuring the cost of equity are:
        • Capital Asset Pricing Model (CAPM)
        • Build-up Method
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 16. Build-up Method
      • Build-up Method – uses returns from alternative investment choices to match the risk of the business
      • Components:
        • Risk free rate (yield on long-term US Treasury bonds)
        • + Equity risk premium (i.e. S&P 500)
        • + Size premium (small stocks are considered more risky)
        • + Company specific premium (additional risk factors)
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page Source: Stocks, Bonds, Bills, & Inflation Yearbook by Morningstar
    • 17. Build-up Method - Example
      • Assume the following:
        • Risk free rate = 4%
        • Equity risk premium = 6%
        • Size premium = 5%
        • Specific company risk premium = 3%
        • Cost of equity = 18%
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 18. WACC Calculation
      • Assume:
        • Capital structure = 60% equity and 40% debt
        • Cost of debt = 5% (before tax)
        • Effective tax rate = 40%
        • Cost of equity = 18%
        • WACC = [5% x (1-40%) x 40%]+[18% x 60%]
        • =12%
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 19. Spread between ROIC and WACC
      • The greater the spread between ROIC and WACC the better
      • Therefore, if:
        • WACC = 12% and ROIC = 14%, value goes up
        • WACC = 12% and ROIC = 18%, value goes up faster
        • WACC = 12% and ROIC = 10%, value goes down
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 20. Reducing the WACC
      • Options for reducing the WACC….
      • Increase the debt component of the capital structure
        • But only to a point
        • Consider capital structures of similar publicly-traded companies
      • Decrease the cost of equity
        • By reducing risk
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 21. Revised WACC Additional Leverage
      • Assume:
        • Capital structure = 60% debt and 40% equity
        • Cost of debt = 5% (before tax)
        • Tax rate = 40%
        • Cost of equity = 18%
      • WACC = [5% x (1-40%) x 60%]+[18% x 40%]
      • = 9%
      • Note: 3% decrease in WACC = 33% increase in value
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 22. Revised WACC Lower Cost of Equity
      • Assume:
        • Capital structure = 40% debt and 60% equity
        • Cost of debt = 5% (before tax)
        • Effective tax rate = 40%
        • Cost of equity = 16%
      • WACC = [5% x (1-40%) x 40%]+[16% x 60%]
      • = 10.8%
      • Note: 1.2% decrease in WACC = 11% increase in value
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 23. MEASURING SHAREHOLDER VALUE
    • 24. Value Measurements
      • Valuation is based more on economic principles than accounting or tax pronouncements
      • Historical “GAAP” financial statements or tax returns generally offer little insight about value creation
      • For example:
        • Short term cost reductions
        • Research and development expenses
        • Accelerated depreciation
        • Operating vs. capital leases
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 25. Discounted Cash Flow Models
      • DCF models are generally the most reliable way to measure a company’s value
      • Basic premise - present value of future net cash flow available to the owners
      • Present value determined using the company’s WACC
      • Cash flows beyond the projection period are capitalized into a terminal value
      • Extra caution must be used with young/high growth companies
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 26. Net Cash Flow
      • Projecting net cash flow with DCF models:
      • Start with NOPAT
      • Add:
        • Interest expense (net of tax benefits)
        • Non-cash charges such as depreciation and amortization
      • Deduct:
        • Future working capital needs
        • Capital expenditures
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 27. Basic DCF Formula Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page Value = CF 1 + CF 2 + … CF n (1+ r) 1 (1+ r) 2 (1+ r) n Where: CF = Net cash flow from operations r = Discount rate (WACC)
    • 28. Discounted Cash Flow Analysis
      • Model should be set up with sufficient detail to facilitate evaluating various assumption alternatives, such as:
      • Revenue growth – by product/service/ type or division as appropriate
      • Gross profit margins – by product/service type
      • Operating expenses – separated between fixed and variable and to the extent possible, allocated by product/service line
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 29. Advantages of DCF Models
      • Easy to develop using Excel
      • Easy to update
      • Can be set up to measure impact from various “what if” scenarios, such as:
        • Higher growth rates
        • Improved gross profit margins
        • Increased inventory turnover
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 30. Economic Value Added Models
      • Economic Value Added (EVA) models are based on the premise that value is only created if the company earns a return in excess of its capital charges.
      • EVA = NOPAT – (WACC * invested capital)
      • Positive EVA = value increases
      • Negative EVA = value decreases
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 31. EVA Example
      • Assume the following:
      • NOPAT = $3.0 million
      • Invested capital = $25 million
      • WACC = 10%
      • EVA = $3.0 million – ($25 million x 10%)
      • = $500k
      • Implies that both operating and capital charges have been covered and shareholder value increased by $500k
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 32. EVA Modeling
      • EVA models generally include an analysis of the company’s historical EVA performance and projected future EVA under various assumptions
      • By changing the assumptions, management can evaluate the anticipated impact of certain value improvement initiatives
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 33. Advantages of EVA Models
      • Easy to understand and use
      • Can be used at various subsidiary and division levels
      • Easily tied to incentive compensation plans
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 34. LOOKING FOR OPPORTUNITIES
    • 35. Looking for Opportunities
      • Finding opportunities to improve cash flow requires reliable data and analysis
      • In order to understand where to look for future improvements, you must first understand where things currently stand
      • Example - profitability by product/service line and/or customer/customer type
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 36. Looking for Opportunities
      • When analyzing profitability, consider indirect costs such as:
      • Working capital needs for various product/service offerings
      • Selling and service costs associated with customers/customer groupings
      • Use 80/20 rule to focus on areas most likely have the most impact
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 37. Revenue Growth
      • All products/services have an economic life cycle
      • Cash cows, rising stars and dogs
      • Resources should be allocated appropriately
      • Consider future changes in:
        • Competition
        • Substitute products/services
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 38. Reinvestments
      • Companies that reinvest a significant portion of operating cash flow back into the business will generally have higher and more sustainable growth rates and be more profitable than those that do not
      • Use the ratio of annual investments in operating assets/available operating cash flow (operating cash flow before reinvestments) to evaluate effectiveness
      • If trending up – investments are paying off
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 39. Operating Costs
      • Lower operating costs per unit sold can be a significant competitive advantage
      • Operating efficiencies – are best practices being utilized?
      • Effective use of technology?
      • Volume efficiencies
        • Focus on doing what the company does best
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 40. Balance Sheet Analysis
      • Capital structure – optimal use of leverage?
      • Under capitalized?
      • Working capital
        • Generally a big user of operating cash
        • Analyze by product line/division, etc
        • Deal with slow moving/dead inventory
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 41. Balance Sheet Analysis – Con’t
      • Consider assets not being efficiently utilized, such as:
        • Real estate holdings
        • Non-operating assets
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 42. DEVELOPING A PLAN
    • 43. Planning for Improvement
      • Determine the Company’s current value
      • Develop a plan for improving it
      • Monitor the plan and make adjustments as necessary
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 44. Business/Strategic Plan
      • Every business should have a strategic plan
      • Road map for how the business’ goals and objectives will be accomplished
      • Once developed – it must be effectively communicated to the employees who will be responsible for making it happen
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 45. Business Plan
      • The business/strategic plan should include measurable goals and objectives such as revenue growth and profitability by product/service line/division, etc
      • Details for how it will be accomplished
      • Assign responsibility
      • Require accountability
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 46. GETTING EMPLOYEES ON BOARD
    • 47. People
      • People are the core of all businesses – most valuable asset
      • In order for the company to be successful and grow, it must have the right people and motivate them
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 48. Performance Based Compensation
      • Performance based compensation plans are an effective tool for motivating employees and aligning their interests with those of the owners
      • Tying compensation to certain performance metrics, such as EVA targets, gives employees a sense of ownership and strong incentives to help the company achieve its goals
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 49. Performance Based Compensation
      • To be effective, the performance criteria must be:
        • Achievable
        • Measurable
        • Clearly communicated
      • Requires regular feedback and information that allows the employee to monitor their progress throughout the year
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 50. Performance Based Compensation Example
      • Base compensation plus a bonus pool
      • Bonus pool tied to certain EVA targets
      • Minimum EVA required for any bonus
      • Bonus pool increases based on the amount that actual EVA exceeds minimum threshold
      • EVA threshold should be increased each year
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 51. Value Creation is a Process
      • The items discussed during this presentation represent a process for enhancing shareholder value on a long-term, sustainable basis
      • No short-cut/easy “one size fits all” solution
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 52. Summary
      • Privately-held companies are investments
      • Valuation is a forward looking concept
      • Management’s job is to increase shareholder value
      • Value creation requires:
        • Revenue growth + ROIC > WACC
      • Debt is cheaper than equity
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 53. Summary
      • Use DCF models to measure value
      • Use EVA models to monitor value creation efforts
      • Analyze operating data to look for improvement opportunities
      • Deal with underperformers (people and products)
      • All products/services have a life cycle
      • Companies that reinvest in their future will probably have a brighter one
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 54. Summary
      • Lower operating costs per unit are a competitive advantage
      • Allocate resources to the best opportunities
      • Competitive advantages don’t last forever – must be constantly looking for ways to improve
      • Every business needs a strategic plan – road map
      • Keep employees interests aligned with the owners
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 55. ADVISING SELLERS
    • 56. Advising Sellers
      • For most business owners, the business is their most valuable asset. When they decide to sell, they generally need help with:
      • Determining a realistic range of values that a buyer might pay for the business
      • Making sure the company is properly positioned to maximize its value
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 57. Advising Sellers
      • Owners often have unrealistic views regarding the value of their business
      • Will the anticipated net proceeds be sufficient to support the seller’s lifestyle/needs?
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 58. FMV vs. Investment Value
      • Fair Market Value – the price at which the property would change hands between a willing buyer and a 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 reasonable knowledge of the relevant facts.
      • Investment Value – The value to a particular investor based on individual investment requirements and expectations.
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 59. Strategic vs. Financial Buyers
      • Financial buyers - are generally just investors
        • Less opportunities for synergies
      • Strategic buyers - are already in the business
        • Will often result in a higher value due to more opportunities for synergies
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 60. Methodologies for Determining a Range Of Values
      • DCF models
        • With various growth and profitability assumptions
        • Estimating potential buyer synergies
      • Merger and acquisition transaction method
      • Public Guideline Company method
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 61. DCF Models
      • Two Scenarios
        • Value of the business “as is”
        • Estimated investment value to a strategic buyer
      • (Results in a high/low range of values)
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 62. Merger & Acquisition Method
      • Requires reliable transaction data
      • Common databases include: Pratt’s Stats, BizComps, IBA Transaction Database
      • Common search criteria:
        • SIC code
        • Revenue
        • Transaction date
        • Geographic area
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 63. Public Guideline Company Method
      • Difficult to use for most small/mid-size private companies
      • Community banks
      • Search SEC filings for acquisitions
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 64. Is the Company Ready to Sell?
      • Are there substantial risks that can be reduced?
      • Any problems with the financial statements?
        • History of employee theft/embezzlements
      • Accounting records/systems up to date and reliable?
      • Non-competes/employment agreements with key employees?
      • Current economic environment
      • Any non-operating assets that should be carved out?
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 65. Managing Engagement Risk
      • Engagement letter
        • Not being engaged to perform a forensic investigation of the accounting records
        • Not offering investment advice
      • Fees – hourly or contingent (success fee)?
      • Check with malpractice carrier
      • Document work performed and recommendations
      • Seller’s remorse (i.e., buyer re-sells for substantially more)
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 66. CASE STUDIES
    • 67. Case Study #1
      • Local beer distributor sold to another distributor:
      • Annual sales of approximately $15 million
      • Low profitability – to much overhead
      • FMV range = $3 - $5 million
      • Sold to strategic buyer (another distributor) for approximately $11 million
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 68. Case Study #2
      • Telecommunications company sold to a strategic buyer wanting to expand market share:
      • Annual sales of approximately $25 million
      • Very thin margins
      • Contracts and key relationships with several major convenience store chains across the US
      • FMV = $5 - $8 million
      • Sold for $18 million to a strategic buyer
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 69. ADVISING BUYERS
    • 70. Advising Buyers
      • Evaluating potential targets
      • Helping them to not overpay
      • Due diligence issues
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 71. Identifying Potential Synergies
      • Enhanced revenue growth
      • Reduced costs
        • Eliminating excess overhead
        • Personnel cuts
        • Lower employee benefit costs
      • Improved efficiencies
      • Changes in management
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 72. Factors to Consider
      • Buyer’s WACC vs. Target’s WACC
        • Separate business with separate risks vs layering additional revenue and expenses into current operations
      • Can the business relationships be effectively transitioned to the new owners?
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 73. Managing Engagement Risk
      • Engagement letter
        • Not engaged to perform a forensic investigation of the accounting records
        • Not offering investment advice
        • Management makes all decisions
      • Check with malpractice carrier
      • Document work performed and recommendations
      • What if there is fraud and it was not discovered?
      Prepared for 2009 Southeastern Accounting Show August 27, 2009 Incomplete Work Product Page
    • 74. W. James Lloyd, CPA/ABV, ASA, CBA Pershing Yoakley & Associates, P.C. (865) 673-0844 [email_address] www.pyapc.com
      • Questions?

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