Corporate Finance in Atlantic Canada

Commentary on corporate finance issues for small- & mid-market private companies in Atlantic Canada

Archive for September 2011

“Few people have the training and experience to objectively assess the worth of a company”

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Check out this insert that appeared in the Globe & Mail in July on how CEOs perceive value and valuations, including the quote in the title of this blog post.

I particularly like this quote:  “It takes more than one transaction to be an expert” … something executives (and CAs in particular) should heed, given many transactions are attempted without any independent valuation or M&A advice.


Written by Dan Jennings

September 28, 2011 at 9:17 am

Posted in CF Musings

NS court approves $25 mil in compensation to immigrant investors

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NS government settled the class action suit with immigrants who claimed the investment stream of the immigration program failed to deliver what they were promised.

While this program had more than its share of problems, we as a province still need to focus on immigration as a partial solution to our aging demographic challenges.

Written by Dan Jennings

September 27, 2011 at 12:41 pm

Posted in CF Musings

What are maintainable cash flows?

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Businesses that are successful, viable operations are generally valued by buyers using going concern cash flow-based approaches, such as the Capitalized Cash Flow technique (“CCF”).  This methodology is typically used for mature businesses with relatively stable earnings that can be reasonably estimated into the future and/or when a specific multi-year forecast of cash flows is not available (i.e. as in most small businesses).

The two principal components of the CCF methodology are the annual maintainable net cash flows and the risk-adjusted rate of return.  The stream of maintainable cash flows after-tax is “capitalized” by this rate of return to arrive at the value of the business.  This methodology is very common in our marketplace and is the preferred technique of most acquirers of small and mid-market businesses.

So, how is the level of maintainable cash flow evaluated and determined?

Maintainable cash flow is the prospective (i.e. future) annual net income expected to be produced from the operating activities of the business.  In other words, maintainable cash flow represents the best estimate (at a point in time) of the expected future income from the operations of the business.   Because no one can predict (with certainty) the future, maintainable cash flow is often expressed as a reasonable range of values.

Assessing an objective and reasonable maintainable cash flow level requires experienced judgment and analysis of both:

(a) the business and its prospects; and,

(b) the prevailing and prospective economic and industry conditions and how these conditions affect the entity’s operations and reported results.

Most valuators and acquirors start with historical cash flows as a guide to future maintainable levels.  That’s why you see many of these analyses starting with an average of the last 5 years of cash flows.  But, that 5 year average begins with an assumption that history is indicative of the future … which it often is, but certainly not always.

Historical cash flows have to be adjusted (or “normalized”) to reflect the future expected results, usually for 4 types of adjustments:

  1. In owner-managed businesses in Canada, owner compensation must be adjusted to market levels (because Canadian tax laws allow owner-managers to take their share of profits in a variety of ways, i.e. not just salary).  The same applies to transactions with related parties under common ownership.
  2. Revenue and expense items have to be adjusted for nonrecurring and/or unusual items to reflect prospective operating results on a go-forward basis.  For example, if you experienced a loss 3 years ago because you experimented with a new division that has now been shut down, then the portion of the loss related to the new division should be normalized (i.e. removed) for the purposes of the valuation because it is not expected to be there in the future.
  3. Rapid sustainable growth.  The results 5 years ago of a business that has grown 15% a year are not relevant to how a buyer would perceive value today, i.e. it is a very different business today than 5 years ago.
  4. Significant changes to the competitive landscape and/or the industry.  The arrival or exit of competition can dramatically change the expected results of a business such that history may no longer be a guide for the future.

Management budgets and projections should also be considered in the determination of maintainable cash flow.  These budgets must be assessed for reasonableness and achievability before being included in the range of maintainable.

Finally, a valuator’s (or buyer’s) view as to a future maintainable level of cash flow must also be considered in the context of the risk-adjusted rate of return (or multiple) applied to that cash flow.  In other words, the determination of the two components of value (i.e. expected cash flow and perceived risk/return) are interconnected and cannot be determined in isolation.  For example, if I’m buying a business based on future expected cash flows that are much higher than historical normalized cash flows, then I apply a higher risk-adjusted rate of return (a lower multiple) because of the added risk I’m taking on by using those unproven cash flows.

The next time someone tells you they valued or priced your business based on the average of the last 5 years of cash flows, consider whether the last 5 years are representative of the future maintainable range of your business.  Ultimately, a buyer is buying the next 5 years of cash flow, not the last 5 years …. the last 5 years are only a guide as to what he/she can expect.

Written by Dan Jennings

September 27, 2011 at 12:30 pm

Posted in CF Musings

Growing businesses require working capital investment

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This Globe and Mail article talks about an event planner who is reluctant to ask for better terms from her clients while she struggles with paying costs upfront while her clients pay her in 60-90 days.

While the article doesn’t mention the words “working capital”, it is a common challenge for many businesses, particularly rapidly growing ones.  Working capital is the amount of cash a business has tied up in receivables and inventory, less the cash freed up from owing payment to suppliers.  No financial institution will lend you 100% financing on these assets (although some, like factoring, can effectively come close).  And most businesses have a gap between when you pay expenses and how long it takes to collect your receivables.  If you combine these two realities, almost every business requires an equity investment in working capital in order to operate, and rapidly growing businesses require an even larger such investment as financing struggles to catch up.

Some businesses require larger investments in working capital than others.  Landlords, for example, collect rents at the beginning of the month, so their investment in working capital should be much less than say, a service business that provides services to business customers (because the primary expense is people, who get paid weekly or bi-weekly, while the customers pay in 30-60 days).

In addition to growth, a common challenge for some businesses is earning enough profit to justify the investment in working capital.  If you have one customer who pays you in 30 days and another customer who pays in 120 days, you need to recognize that the same operating profit from both customers is probably not sufficient, given the larger investment in one customer versus the other.

This issue comes up in valuation and M&A transactions, i.e. whether the returns being generated are enough to warrant the investment required from a purchaser.  I see this commonly when a long-established business is being sold, and working capital has been funded by the long-time buildup of retained earnings, and the seller is surprised when the buyer balks at paying “face value” for receivables and inventory for a business that is generating a limited amount of profit.

To go back to the event planner at the outset, she has to either find a way to reduce the gap between receivables and payables (such as asking customers to pay a portion of the fee upfront) or she has to accept the gap as a cost in her business (in which case, she will likely have to explore more expensive forms of capital, such as factoring receivables or raising equity capital).

Written by Dan Jennings

September 21, 2011 at 2:19 pm

Posted in CF Musings

Muskrat Falls best choice, according to consultant

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A Navigant Consulting report released Thursday says the proposed $6.2-billion Muskrat Falls hydroelectric project is the cheapest energy supply option for Newfoundland and Labrador.  This report finds practically the opposite of what the federal-provincial joint review panel said last month, i.e. that Nalcor Energy had not proven the viability of the project.

Regardless, the hydroelectric project and the significant mining activity in Labrador bode well for the economy of the province.  Perhaps that’s why we’ve seen a number of acquirers searching for acquisition targets in Newfoundland this year.

Written by Dan Jennings

September 16, 2011 at 1:51 pm

Posted in CF Musings

2 kinds of buyers for your business

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The link above is to a Globe & Mail article on the difference between financial buyers and strategic buyers — one of my favourite areas of advice for entrepreneurs.

Financial buyers buy a business based on an expected future stream of profits and growth, while strategic buyers buy a business for what its products/technology/people can do once integrated into their own business.  In some cases, strategic buyers can (and often will) pay more than financial buyers … the challenge is that not all small businesses in all industries can attract strategic buyers.

If I want to buy your existing dry cleaning business (and I’m not in that business), then I am an example of a financial buyer.  I can only afford to pay so much because I’m using my equity and some debt to acquire your stream of future cash flow at a ‘reasonable’ rate of return.

But, buying Radian6 for ~$320 mil is an example of a strategic buyer, because Salesforce intends to blend Radian6’s product offering with its own, hence why Salesforce said “this acquisition will accelerate our growth [and] and extend the value of all of our offerings.”  To a well-capitalized public company like Salesforce, the value of Radian6 is potentially far more than the future stream of cash flow from Radian6’s existing product lines on a standalone basis.

The other difference is that strategic buyers are often (but not always) public companies that have much greater access to capital than private companies.

See my earlier blog posts for other examples of both types …

Written by Dan Jennings

September 12, 2011 at 1:12 pm

Posted in CF Musings

Major Drilling acquisition

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Moncton, NB-based Major Drilling (TSX:MDI) announced a deal to acquire Bradley Group, a privately owned driller in Rouyn Noranda, Que, for $72 mil cash plus assumption of debt.  The transaction will add 124 rigs to Major’s existing base of 571 rigs worldwide, and give it access to new markets (Philippines) and strengthen others (Ontario & Quebec).

Written by Dan Jennings

September 12, 2011 at 12:13 pm