Showing posts with label valuation. Show all posts
Showing posts with label valuation. Show all posts

Sunday, July 13, 2014

Differences Between EBITDA and Operating Cashflow

Posted by John Nicklas



EBITDA is often used and confused as an approximation of operating cash flow. Many business professionals (CPAs, business owners, bankers, attorneys and others) struggle to understand the differences between EBITDA and cash flow from operations within a business. Below are some differences between these business metrics.

Definitions of each as provided by Investopedia.com:

  1. “EBITDA” is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
  2. “Operating Cash Flow” or “OCF” is (in accounting) a measure of the amount of cash generated by a company's normal business operations. Operating cash flow is important because it indicates whether a company is able to generate sufficient positive cash flow to maintain and grow its operations, or whether it may require external financing. OCF is calculated by adjusting net income for items such as depreciation, changes to accounts receivable, changes in inventory and other working capital items. 
The table below compares EBITDA to OCF.  A 3rd column (“Example”) is presented for discussion purposes:
EBITDA-Cash-Flow-Differences

A few comments about EBITDA:

  1. EBITDA is used widely and is easy to calculate by taking income from operations (reported on the income statement before interest and taxes) and adding back depreciation and amortization (reported as a line item or items in the cash flow statement).
  2. EBITDA is used everywhere, from valuation multiples to the formulation of covenants in credit agreements. It is the “go to” or “de facto” metric in the business community.
  3. EBITDA allows you to compare the profitability of different companies by cancelling the effects of a company’s capital, financing and tax entity structure.
Keep in mind the EBITDA does not equal cash flow. The most obvious shortfalls of the EBITDA calculation as a measure of cash flow are that the EBITDA calculation does not (1) consider the increase (or decreases) in working capital accounts that may fluctuate with a business as it grows and (2) it does not subtract capital expenditures that are needed to support production, especially in a manufacturing environment.

In the table above, Operating Cash Flow(“OCF”) does a better job of adjusting for the increasing working capital needs of a growing company, but fails to add back interest expense and income tax expense, items that make it easier to compare businesses with different capital and entity tax structures.

In addition to the fluctuation of working capital, we should include “normal” capital expenditures in our evaluation of the profitability of a company. Capital expenditures are necessary to support production and maintain a company’s asset base. As presented in the table above, capital expenditures may significantly impact cash flow if the business is capital intensive and/or has a need for expanded capacity or updated equipment.

EBITDA is, and will probably always be, the key business metric for evaluating the performance of a business to its peer group because it is widely used and easy to perform. However, keep in mind that EBITDA is not cash flow and that many other factors should be considered.




John Nicklas is a Vice President in our Assurance Service Group at Meaden & Moore. He has over 19 years of experience serving the accounting and business advisory needs of middle-market companies. He is born and raised in Northeast Ohio and works in our Cleveland office.

Sunday, October 6, 2013

8 Mistakes Entrepreneurs Make When Pitching To Investors

Rather than waste my carefully considered advice, I offer it instead to you:

1. The Elevator Pitch Is Longer Than One Minute 
 If your “elevator pitch” is longer than one minute, you will have a very difficult time raising money because you will not have enough time to make a compelling investment case. This opportunity will likely arise in an elevator, at a cocktail party, or ever so carefully wedged between small talk with friends and their acquaintances. So you must make the pitch short and to the point, and make sure it showcases your knowledge.

The only way to accomplish all of the above is to have a well-crafted pitch that takes no longer than a minute to deliver in an unhurried — but practiced — manner. Any longer and the potential investor will most likely have moved on either physically or mentally. Needless to say, this is not easy. You must be able to condense all of the information in your PowerPoint presentation (see 2 below) and business plan (see 3 below) into a brief summary.

2. The PowerPoint Presentation (aka “the Deck”) Is Too Long 
Professional investors, such as venture capitalists and serious angel investors, do not have long attention spans. The reason is not necessarily that they have attention deficit disorders but that they need to consider, evaluate, and choose among so many startup investment proposals that 30 minutes of uninterrupted time is all you can reasonably expect to have to present your proposal.

If you have been successful in the elevator pitch, you must be able to present a slide presentation in about 15 minutes, then leave time to answer questions within another 15 minutes (see 8 below). Although you may be granted more time, you must also prepare for the possibility of less time, so you need to ensure you get your main business points across before the investor conveniently excuses himself due to a “prior commitment.” Bottom line: 15 minutes of presentation means no more than 12 to 15 slides. 

3. Not Having a Factually Supported, Well-Written Executive Summary 
At the end of the day, the key to raising money is to have a carefully thought-out summary of the investment proposal (aka “the executive summary” or, the longer form, “business plan”).

When raising money, you need to interest VCs or angel investors with the elevator speech and PowerPoint presentation, but you only close on the money after the investor reviews, questions, and buys in to your entire business plan. So you must spend a significant amount of time drafting a coherent and persuasive executive summary or business plan that sets forth, among other things:
  • the problem that the startup will be solving
  • the size of the market the startup will be addressing
  • a sustainable competitive advantage
  • the expected revenues and costs of the startup that are supported by realistic and detailed assumptions and projections
  • a description of the startup’s management team
  • the exit for the investors (see 4 below)
The best elevator speech in the world will not result in any money unless you can deliver an analytical and believable business plan explaining how an investment in the startup will make its investors rich.

While there are a few experienced entrepreneurs out there who can do this in an evening, you should plan to spend weeks, if not months, perfecting a business plan — otherwise the time spent on the elevator speech and PowerPoint will have been wasted.

4. Overlooking a Realistic Exit Strategy for Investors 
An entrepreneur’s thinking process is often to make the world a better place, create a long-term business that will keep him or her engaged and richly employed, and bequeath a legacy that will take care of the entrepreneur’s children and their children. In contrast, the investor’s thinking process is usually “How do I make a lot of money in a short to moderate time frame (3 to 7 years)?” Guess whose thinking process controls whether the entrepreneur closes on an investment?

Therefore, you must ensure your PowerPoint presentation and business plan address how the investor will make money (aka “the exit”) from investing in your business proposal. Many entrepreneurs never address this basic need of investors. To avoid this oversight, you must be prepared to answer an investor’s questions about how the investment will be monetized through, among other things, licensing agreements with larger companies or a strategic sale of itself to a larger company, not just an IPO scenario in which you see yourself becoming CEO of a Fortune 500 company (something that almost never happens).

5. Asking for a Non-Disclosure Agreement 
Almost all entrepreneurs are convinced their business idea will result in enormous wealth and, therefore, is at risk of being stolen by an unscrupulous investor. So their first thought is to have the potential investor sign a “bulletproof” non-disclosure agreement (“NDA”). But for many professional investors, such a request is a non-starter, meaning there is no longer any reason to see the 12-slide PowerPoint or incredibly detailed business plan.

Unless the entrepreneur has a business idea on the order of “Son of Google,” most professional investors, including both VCs and serious angel investors, will not sign an NDA because they know that there is a strong likelihood that they will have seen the idea before and will likely see it many more times in the future. Consequently, they cannot sign a document that will surely lead them to a lawsuit in the future from either this particular entrepreneur or another one.

6. Submitting Investment Proposals “Over the Transom”
Raising money is all about building credibility with investors. No investor wants to invest in a deal that nobody else is interested in pursuing. Investors are very herd-like and often need the validation of others investing with them before they will “pull the trigger.”

Given the herd mentality of investors, you should never attempt to raise money by purchasing or collating a mailing list of VC firms or angel investor groups and then just mailing a proposal in the hopes someone will contact you to set up a meeting.

This is not to say that there are not many entrepreneurs who, in fact, do mass mailings. My point is that such an approach is likely to be D.O.A. Venture capitalists and serious angel investors are often deluged with unsolicited proposals, which sit in slush piles waiting to be opened. The only real reason they might be opened is because a friend or professional acquaintance has alerted the investor that the proposal deserves a read. In other words, someone has acted as a reference or provided a recommendation, preferably before the proposal has been delivered. Only then do you have a serious chance at receiving that special phone call.

7. Discussing Valuation Too Early On in the Negotiations 
The courtship ritual of most couples does not start with a discussion of how much each person will be worth seven years from their first date, and how it will be divided between them if and when they part. And neither should an investment presentation begin with a similar discussion.

The reason an entrepreneur often seeks an investment from VCs and experienced angel investors is to get a reliable indication of the value of their startup, which is what experienced investors do for a living. So there is no real point in preempting the process by insulting the VC or angel investor with an unwarranted starting point for a valuation.

As some would say, you should just “let nature takes it course” and wait for the investor to begin the discussion of valuation and pricing with a term sheet. Any other approach risks an early termination of negotiations.

8. Failure to Listen 
You need to “leave your pride at the door” when making an investment presentation and be open to the investors’ suggestions. The fundraising process can be grueling because experienced investors tend to ask numerous questions that likely have been posed to you before, questions that test your business model and technology platform so all parties might realize the best way of structuring an investment.

Most of the time, the questions are offered in the spirit of openness to justify the investment of such a large sum of money. But rather than viewing the questioning process as an exploration of alternatives by an investor who is obviously interested in the startup (otherwise why else would the investor have met with the entrepreneur in the first place?), some people reactively resist suggestions to consider changes to their business model or technology platform. Such a reaction is likely to cause a thoughtful investor to move on. You should instead take the time to consider the investor’s questions and suggestions, and view the process as useful insight into his or her thinking.

I end with number 8 because such a “failure to listen” was the chief mistake made by my own child. But I guess my own mistake was forgetting that children never listen to their parents either.

Friday, August 23, 2013

How to make your business more attractive for sale

Arek Jajus cleans the windows of a Toronto restaurant on Jan. 5, 2011.

The dismal financial results for 2009 no longer need to be included in a company’s books. For any business looking to sell, this significant milestone allows for a marked improvement when potential buyers look at the performance of the past three years. The conversation doesn’t have to start with: “We looked at your financial statements. What happened in ’09? Want to talk about that first?”

That said, there is still a noticeable gap in valuation expectations between buyers and sellers. “The market downturn stripped out the profits for private companies and the survivors reduced and reinvented their businesses to add to their top line,” says Bob Gorrie, owner of Gorrie Marketing Services. “These owners have put a great deal of sweat equity into their businesses, and unfortunately that extra hard work and planning is not reflected in their financial results.”

But as the markets improve, profits are returning and owners interested in selling are watching their industry cycles like hawks for the upswing, waiting to get the timing right. A more relevant question for these owners is “where is my own business in its life cycle?”

For any business owner contemplating a sale in the next few years, here are a few ways to add to the valuation:

Does your business have solid management?
The owner may be leaving but buyers want to know whether there’s a team in place with big goals to drive the business forward with equal determination. Having a succession plan is critical, but when Crosbie & Co. recently conducted an owners’ survey, it revealed that fewer than 5 per cent have a written document with a strong operator or family member ready to take over. Owner-operators have built their lives around running their businesses and they do not want to let that go. This reluctance may prevent them from seeing the importance of planning for their own exit and they will get dinged on their company sale price for this omission.

Are your key processes institutionalized?
“There is the risk that the company incurs a fatal loss of knowledge and connections upon the exit of the owner,” the president of a manufacturing business told me. “The earn-out helps, but two to three years does not make up for 30 years experience in a company. One way to mitigate this risk is to bring in a guy like me.” Paying a high-quality CEO for a few years will help the owner of a windows manufacturer convert “in the head” knowledge to written processes. “We preserved the knowledge and demonstrated the existence of a reliable management team to a potential buyer,” the president added.

Do you know good buyers?
The sale price of a business is what buyers offer and when a company is in the growth part of its business cycle, there will be multiple offers and phone calls from all sorts of interested parties. “I know the ‘I’m comfortable with my business’ owners where the offers to buy have made great sense,” says succession planning coach Janice Lahiti. “The owners don’t do it because they think their ability to influence a variety of broader agendas will diminish.” As the business hits the mature stage of its life cycle, which often occurs in tandem with the owner’s life cycle, suddenly the pool of multiple bidders dries up and as Janice says: “The owner can no longer command the multiples they want.”

The owner may also miss the opportunity to sell to a buyer who will structure the sale so that the majority of the company is purchased but the owner can keep 20 per cent to 30 per cent with a fixed medium-term buyout schedule. They can also have limited management or board involvement. This structure keeps the owner involved mentally and financially in his or her ‘baby’ while taking some money off the table to free up time to pursue other interests.

What is your opportunity cost, really?
Melanie Kau exited her successful family business, Mobilia, to take on the challenge of running Le Naturiste. “The ‘what next’ after you have worked for 15 to 20 years in a business prevents people from asking themselves the cost of staying where they are because they are comfortable. I know what that feels like because I have just been through it. Therein lies a great deal of value with the experience the entrepreneur has built up: sometimes the business is more like a cage than a platform.”

Jacoline Loewen is a director at Crosbie, which focuses on succession advice for family businesses and closely held small to medium-sized enterprises. Crosbie develops customized strategies, particularly in relation to M&A, financing and corporate strategy matters. Ms. Loewen is also the author of Money Magnet: How to Attract Investors to Your Business.