Addition By Subtraction


A Formula for Increasing the Value of a Business

Date August 2015

When it's time to sell a business, the adage "The whole is greater than the sum of its parts" may seem the natural truth. But, when a company is faced with a segment that is losing money, businesses may need to reconsider their understanding of that old saying. It is indeed possible, and in fact relatively common, for businesses facing these circumstances to improve their marketability - and their selling price - by divesting of underperforming assets prior to going to market. Not only will businesses benefit from this strategy but so will the providers of capital, such as lending institutions. We'll share the simple math below.

Although valuing a business is complex, a typical approach is for prospective buyers to apply a multiple to the consolidated EBITDA to determine an enterprise value. Smaller companies often trade for lower multiples, typically between 3x to 5x normalized EBITDA, while larger firms may fetch higher multiples and price tags. Higher levels of EBITDA indicate more attractive acquisition candidates by the market. So before going to market, business owners should consider how to maximize the consolidated EBITDA of their company. While there are many strategies for improving profitability prior to sale (i.e. streamlining operations, eliminating redundancies, renegotiation of supply agreements, etc.), one that can sometimes make the biggest impact is often not considered. Rather than investing cash flow to cover losses generated by underperforming divisions, locations, product lines or SKUs, business owners might be well-served to consider the benefit of selling these assets on the business' marketability and value prior to going to market.

When does 2 – 1 = 3?

Consider, for example, a company generating $10 million of EBITDA in an industry that is selling at 5x EBITDA; equal to a $50 million potential valuation. If one division within this business is losing $1 million in EBITDA per year, it hampers profits and detracts from the potential overall value. With some foresight, the seller could divest of the money-losing division prior to taking the entire company to market, increasing its cash flow to $11 million by actually making itself smaller. The leaner company is conceivably worth much more when its revenue is multiplied by the same 5x EBITDA, equaling a $55 million valuation. Thus, we can see that the greater whole of the business with the underperforming division, does not necessarily equate to a higher selling price.

Beyond stemming the loss of income, the surviving business' financial position is often further strengthened by the proceeds generated from the sale or disposal of the underperforming unit. By increasing the operating margins of the retained operations, the company becomes more attractive to a potential buyer. Any assessment done by a buyer on the quality of earnings is likely improved by shedding the unprofitable division or assets. And the business can then focus on its core competencies, creating an enterprise that is well-defined and achieves its maximum market value. Even in instances where the divestiture results in a loss, the cash generated from the sale could more than offset that loss if it's redeployed wisely, such as to update facilitates or purchase new equipment that drives additional efficiencies for its principal business, further increasing the enterprise value.

Highly competitive market requires differentiation

The Financial Times reported that buyers paid record valuations for US takeover targets during the first half of 2015, averaging 16x EBITDA, far surpassing the previous high of 14.3x in 2007. However, questions are already being raised about the sustainability of this boom. Businesses interested in standing out and achieving the greatest return in this competitive market should consider what strategies could be employed now to increase EBITDA down the road. Even for businesses that are not considering selling today, this type of strategic planning is what helps certain sellers end up on top when they do pursue that course.

When the goal is value maximization, it's important to take a frank look at all components, without sentimentality or bias. It also involves continual and thorough examinations of profitability and performance of all business segments to support well-informed decisions. Small to midsize businesses that lack robust accounting may benefit from engaging a business valuation expert to understand its current enterprise value and assist in identifying opportunities for margin growth. Appraisers work cooperatively with investment bankers, as well, who provide critical insight to the M&A market and help companies prepare for a sale.

Not only business owners, but also lenders, have an interest here as well. Banks may themselves benefit from encouraging portfolio companies to explore this strategy. Sometimes an external perspective may identify options not previously considered. When executed successfully, the added cash flow provides additional funds to pay down debt or to comply with loan covenants. And by solving issues before the buyer has to, a quicker transaction is facilitated, which is beneficial to all investors of capital in the enterprise.

Divesting of underperforming business segments may be one of the simplest strategies for improving enterprise value. Make sure it is not overlooked. It is an effective way to deliver EBITDA growth and increase the attractiveness of a business investment. Individuals who are unsure how to assess which aspects of a company, if subtracted, may add to the value of the business, consider the insight an independent business appraiser can bring.