Issue #12

Society Venture Investments is an investment firm. We invest in small businesses whose impact strengthens communities and promotes long-term growth. If you’re thinking about selling your business, I’d love to chat!

Inspired by David Sumpter’s “The Ten Equations that Rule the World,” I decided to turn the lens on small business M&A. Let's distinguish between what’s important and what’s truly influential, focusing on universally applicable equations. In retail, metrics like Days Sales Outstanding and Days Payable Outstanding are critical, while a SaaS company might barely glance at them. With that context in mind, let’s dive in and uncover the numbers that drive the deal-making engine.

1. Adjusted EBITDA

2. Networking capital

3. Discounted Cash Flow

4. EBITDA Multiple

5. Capitalization of Earnings

6. Net Orderly Liquidation Value

7. Amortization Payment

8. Debt Service Coverage Ratio

Financial Analysis

1. Adjusted Earnings Before Interest Depreciation and Amortization (EBITDA)

Adjusted EBITDA strips away the fluff, offering a clearer picture of a company's real operating performance by excluding non-recurring, irregular, and non-cash expenses. This adjustment lets buyers zero in on the sustainable earnings potential, making valuations more accurate and comparisons with other investment opportunities far more meaningful.

⚠️ The Rub: Calculating Adjusted EBITDA can be a real headache. You have to adjust for one-time expenses, owner perks, and other discretionary costs that aren’t always consistently recorded. Small businesses often have looser accounting practices, which means some expenses might be underreported or overreported. Plus, deciding what counts as a "non-recurring" expense is subjective and can lead to inconsistencies and disputes. All this makes it tough to nail down a truly accurate and comparable EBITDA figure.

2. Net Working Capital

Net Working Capital (NWC) is crucial because it measures a company's ability to cover short-term liabilities. A positive NWC means the business can keep running smoothly and meet financial obligations, reducing risk. NWC directly impacts the purchase price by adjusting for the actual working capital needed, ensuring a fair valuation. It reflects management effectiveness, supports cash flow management, and aids in strategic planning and integration, giving a clear view of the company's financial health and stability.

⚠️ The Rub: It’s a simple formula, but in small business acquisitions, it can be very complicated. Differences in accounting practices and unrecorded liabilities can throw off the numbers. Small businesses often have inventory that is not recorded using GAAP principles and unusual accounts receivable/payable cycles, making it tough to pin down a consistent and reliable NWC figure.

Valuation

3. Discounted Cash Flow (DCF)

The intrinsic value of a small business is the present value of future cash flows. If you don’t believe that, please put this aside and resume your normal daily activities. If you do believe that, you recognize that you have to figure out the magnitude and timing of cash flows as well as the appropriate rate at which to discount them.

⚠️ The Rub: Accurately projecting future cash flows is really tough due to the inherent volatility and unpredictability of small business operations. Additionally, determining the appropriate discount rate is complicated by the lack of comparable market data and the higher perceived risk associated with small businesses. This complexity often requires deep industry knowledge, extensive market research, and a thorough understanding of the specific business’s operational dynamics.

4. EBITDA Multiple

EBITDA multiples are by far the most widely used valuation metric in small business acquisitions, providing a quick and straightforward way to estimate a company's market value by multiplying its EBITDA by an industry-specific multiple.

⚠️ The Rub: Determining the appropriate EBITDA multiple for a small business is particularly challenging due to the lack of readily available market data and the wide variability in multiples across different industries and business sizes. Small businesses often have unique characteristics and risk profiles that may not be adequately captured by generic industry multiples. Additionally, factors such as market conditions, competitive landscape, and the specific operational strengths or weaknesses of the business can significantly influence the applicable multiple, necessitating a nuanced and in-depth analysis to arrive at a fair and accurate valuation.

5. Capitalization of Earnings

The Capitalization of Earnings involves estimating the value of a business by dividing its expected future earnings by a capitalization rate that reflects the business's risk profile and market conditions. This method is particularly useful in sale leaseback transactions, where it can help to unlock value by converting real estate assets into liquid capital. The proceeds from the sale of real estate can then be used to enhance liquidity, reduce debt, or reinvest in core business activities, thereby optimizing the overall financial structure and driving growth.

⚠️ The Rub: Capitalization of Earnings requires an accurate estimation of future earnings and the determination of an appropriate capitalization rate. Small businesses often experience fluctuating earnings due to market volatility, customer concentration, or operational inefficiencies, making reliable projections difficult. Additionally, selecting the right capitalization rate involves subjective judgment and must account for the unique risk profile of the business, industry norms, and economic conditions, which can significantly impact the valuation outcome and introduce potential for error or bias.

6. Net Orderly Liquidation Value (NOLV)

Net Orderly Liquidation Value is the estimated gross amount that could be realized from the sale of assets, assuming a reasonable time frame to find buyers and conduct an orderly sale.

We care about this equation because it is often used in asset-based lending to determine the value of collateral. In the case of inventory based loans, lenders would lend 85% of the NOLV and is often used to fund acquisitions.

⚠️ The Rub: This calculation is typically done by professional appraisers like Gordon Brothers and Hilco Global.

Financing

7. Amortization Payment

The amortization equation determines the repayment schedule of the acquired company's debt over time. Furthermore, it aids in evaluating the feasibility of the acquisition by aligning the debt repayment schedule with the company’s anticipated revenue streams, thereby mitigating financial risk and enhancing strategic decision-making.

⚠️ The Rub: Differences in loan structures and the inclusion of various fees and penalties can complicate the amortization schedule, requiring meticulous analysis to ensure accurate financial planning and risk assessment.

8. Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio (DSCR) is a critical metric for cash flow lenders as it measures a company's ability to generate sufficient income to cover its debt obligations. A higher DSCR indicates a stronger financial position, suggesting that the borrower can comfortably meet interest and principal payments on their debt.

This ratio is particularly important in commercial bank lending as it helps lenders assess the risk associated with lending to a business. By evaluating the DSCR, lenders can determine the borrower’s capacity to service additional debt, thereby ensuring that the loan provided is within the borrower’s repayment capabilities.

⚠️ The Rub: Small businesses often have fluctuating cash flows and less predictable earnings, making it difficult to ensure a reliable measure of their ability to service debt. Additionally, differing accounting practices and the need to include all relevant financial obligations in the calculation can complicate the assessment, requiring a thorough and detailed analysis to avoid overestimating the business's debt-servicing capabilities.