Dear Insider,

Do you know the value of your company? Do you know how to find it? How do you set a fair share price for employees? How do you know if that offer from an outside buyer is a fair bid? Today we will give you a high-level look at the different kinds of valuations and what they offer.

In our last edition, we shared the story of the ‘dilemma of success’. How many owners have had to navigate the waters of outperforming the purchasing power of their internal buyers. We heard many follow-up questions from you, our readers, prompting us to dive a little deeper into this topic today. How do you determine the difference in fair market valuation sold to employees, vs. out on the open market? What makes a good valuation for your firm?

First- a look at the difference between the two:

 


You’ll notice right away that at certain sizes of adjusted EBITDA, the external model quickly outpaces the internal valuation. Conversely, at lower levels, the internal valuation beats the external valuation. So, which of these is right for you? If your firm has surpassed one million in adjusted EBITDA, chances are, you will start to see this divergence.

First, that question begins with your goals for an exit, if you want to find an external buyer, they are out there. If you want to sell internally, you will need to know who your internal buyers would be and would these leaders make good owners. In either case, you’ll need a clear picture of what the value of your firm is.

Across PSMJ’s 50 years of helping firm owners navigate this question, we’ve learned that there truly is no ‘one-size fits all’ when it comes to valuation. Each firm has subtle nuances that can mean significant differences in the total valuation of a company. These risk adjustments and variables require a valuator who has an expert understanding of our industry and with it, knowledge of what is a risk to a business in the A/E/C world, and what isn’t. A local accountant or generalist who values a variety of industries does not have an in-depth knowledge of the A/E/C industry. Armed with this industry’s knowledge, the right valuators can assign a clear and consistent impact to both your firm’s internal and external value.

The most common adjustment we see is the one made in consideration of an internal buyer. How do you account for the contribution that an employee makes when considering what price to offer them as they look to buy shares? 

For large public companies, this is often a moot point, the contribution of any one shareholder is mitigated by the size of the system they contribute to. For mid-level and smaller firms this contribution is more significant and needs to be factored into a discount of goodwill towards the employee. How does this kind of ‘internal’ valuation compare to an external transaction? 

We generally see that internal valuations apply a discount of 20-60% off an external value. A wide range that can be explained by the dilemma of success. Successful firms are a somewhat scarce item and valuable to buyers who have much larger sources of capital to draw on than a team of employees at a company. The simplest laws of economics indicate that a supply limited, highly demanded item paired with buyers who can meet price requirements, will result in the cost of that item going up significantly.

Conversely, the same firm is (hopefully) the only firm where its employees work and are being considered for partnership. For internal sellers, these internal buyers are the only pool of buyers being considered. This inverts the economics of the external transaction, with a limited pool of buyers facing a valuable commodity. This means the differences in expected value between internal and external buyers can be very significant.

How do you get a clear picture of exactly what the external valuation would be? What could you expect out of a fair market transaction? The market sets the price. We get a picture of what the market would set from comparable transactions that we translate into multiples of EBITDA. Enterprise value in these scenarios translates to purchase price. These values are typically given on a curve and that curve depends on what buyers are willing to pay in a fair process. It takes exposure to a lot of deals to understand what a fair price is. Veteran buyers have a good read on this, as do M&A Advisors like ours. That price is widely set on a multiple of EBITDA.

An interesting approach we have seen recently is that of several large firms overcoming the dilemma of success by adjusting their valuation approach to an entirely unique structure that discounts an external value. The key to the success of this approach harkens back to the discussion around goals and the technique of valuation. These owners are committed to fair value, balancing the possibility of selling externally with choosing to maintain internal ownership. Just like the other approaches, this valuation approach identifies a fair price based on the seller’s goals and chosen market.

Whether you are considering selling shares, or this kind of transaction is a distant goal over the horizon, we hope you’ll do it right. It’s important to remember that the true price of a transaction is whatever amount a willing buyer is willing to pay a willing seller. On the external market, you’ll see a very wide variety of offers for a given seller, and even the most veteran buyers can miss the mark on a deal they set their sights on. The right M&A advisor will help a buyer dial in their offer on a competitive deal to help them land a winning transaction, just as much as they’ll know which buyers are the best fit when supporting a seller to find the right fit for culture and price.

On the internal side, the best transactions are valued correctly and fairly, with a clear picture of how to structure the sale of stock to ease the burden of their cost for internal buyers, often selling shares down over an extended period to a larger pool of individuals.

The last option for exit many owners consider is setting up an ESOP which entails a different valuation methodology. PSMJ has expertise in providing these valuations as well. But that discussion is for another edition.

What has been your experience? Are you a first-generation owner of your firm? Or has your business passed through multiple generations of ownership? Are you exploring the difference in value between inside and outside? Let us know with a comment below.