Strategic Planning for Business Value

Remington Report 2003
By Sharon Handler

Business owners eventually exit, whether planned or unplanned, smooth or rocky, profitable or not. Since it probably represents the bulk of their net worth, business owners share a universal desire to execute a well planned and value enhancing business transaction. It may take the form of divesting all or part of the business, merging with another organization, passing the business along to family members, taking the company public, executing an employee stock ownership plan (ESOP), or worst case scenario, liquidating. Those owners that built their business with investment money probably have a formal exit strategy, but most small business owners have not been that proactive about the process and often don't plan for a graceful transition. Ideally, business owners should begin planning their exit strategy years in advance of actually implementing it in order to achieve their goal of an effective transition. Some thoughtful planning now can increase the value of the business when it's time for the owner to exit. Keep in mind, a bad exit strategy is no exit strategy at all.

Part One of this series, (Eight Driving Forces Behind Home Care Merger and Acquisition Activity, January/February 2003) discussed macro issues such as recent history of merger and acquisition (M&A) activity, types of buyers and current issues that drive valuation. In an industry ripe for consolidation, an increasing number of home health mergers and acquisitions are expected in 2003. This article deals with micro issues relating to divesting your business in the form of a planned sale, including both stock and asset transactions.

Strategy Starts With Planning

Regardless of the size of the organization, there are steps that owners can take to build business value now to assure a profitable exit later. The first step is actively planning for an exit by envisioning the type of exit strategy you hope to pursue - sale, IPO, succession, or ESOP. Each type requires a different plan, corporate structure, and timeline. Define your priorities for sale such a maximizing price or effecting a smooth transition to an agency with similar philosophical and clinical goals. Identify the value drivers most important to buyers. Determine the ideal timeline - it may be within a year, when your business is nearing maximum growth and profitability, or when family members are prepared to assume control. Also, since the value of your business changes with market conditions, they must be factored into your timeline.

Based on your analysis, develop and use a written plan as part of your business strategy so that your business is operated for maximum value at any point in time. After all, your business is your future capital and deserves protection. One of the worst things that can happen to a business owner is nurturing a business for decades, sacrificing a personal life, and then discovering the business doesn't have the expected value. Don't let it happen to you. Buyers don't reward intent, struggles, sacrifices for dreams - only successful execution.

Grow For Value

Business valuation is a combination of art and science, combining both quantitative and qualitative data and methods. In the real world, the value of a business is what a buyer is willing to pay. But that said, there are general and industry specific rules that guide a business owner to grow their business for maximum value.

Financial Metrics

The impact of the accounting scandals of Enron, WorldCom, Tyco and Adelphia are being felt by businesses around the globe. Regardless of company size, business financials are scrutinized more carefully than ever before. Sellers must demonstrate that their accounting methods are accurate and within accepted guidelines. Since audited financial statements are expensive, small businesses usually do not have them, but be sure your financial statements are at least prepared or reviewed by an accountant. During due diligence, your books will be subjected to a similar audit process and need to hold up under intense examination. Be prepared to describe your revenue recognition practices, particularly relating to PPS payments.

Buyers also evaluate financial benchmarks, such as days sales outstanding (DSO), accounts receivable aging, financial ratios (liquidity, leverage, and growth), and net earnings. Additionally, since the implementation of OASIS and PPS, an array of new benchmarks have been developed that provide buyers with detailed financial, clinical, and operating data such as visits per episode, cost per visit, average case mix weight, supply costs, percent of outliers and others.

It's incumbent upon business owners to understand industry averages, compare their organization's metrics, and be prepared to explain any meaningful variations. Interestingly, buyers are equally focused on understanding why a company performs substantially better than industry standards as they are in understanding why a company may perform below them. Because sometimes, above standard performance is due to unique and innovative business practices, but other times, it can be due to practices and strategies, that, for any number of reasons, a buyer may choose not to continue post transaction.

Although there are a number of methods to determine valuation, in this industry, it is usually based on multiples of realizable and representative EBITDA- earnings before interest, taxes, depreciation and amortization. Unfortunately, realizable and representative EBITDA is rarely what you find on an income statement. Numbers must be adjusted upwards (or downwards) to reflect items such as excess owner compensation, perks, and extraordinary, one-time expenses. These adjustments, though, are the easy ones. Others, such as those arising from variations in application of accounting practices - revenue recognition, asset capitalization policies, accounts receivable reserve and write-off policies, and many others - may be more subtle, but no less significant in determining the "right" earnings figure. Since more value is lost from identifying the wrong earnings figure than identifying the wrong multiple, this stage of the process is critical.

With EBITDA in hand, an appropriate multiple must be determined. Although it may seem that multiples are the result of some kind of financial voodoo, they are simply a factor to reflect a buyer's required return on investment. Multiples are simply the inverse of return on investment. For instance, a multiple of 4 times EBITDA represents a 25% return on investment (1 divided by 4 = 25%), the "return" being the EBITDA earned on the price for the business. And the return a buyer requires depends upon their assessment of the risk for the company (more on this later). The greater the risk, the higher the required rate of return, the lower the multiple, and vice versa. Other multipliers may be used such as multiples of annual revenues, or multiples of patients, but these are just different methods of assess value based upon required rate of return.

As you might imagine, multiples vary not only from business to business, but also from industry to industry, and buyer to buyer based on how an acquisition candidate matches a buyer's unique development goals and objectives. As opposed to average "fair market value," this buyer specific standard of value is referred to as "investment value" which is often substantially greater than fair market value. In fact, a recent analysis of closed transactions, found that on average the most strategically motivated buyers paid investment value premiums of 46% above fair market value. This figure is consistent with the independent research published in Business Valuation Update, which showed average investment value premiums of 42% for service companies. With these premiums at stake, merger and acquisition advisors are obsessed with finding the absolute "right" buyer for the "right" seller.

Basic Business Metrics

Basic business metrics, such as strong management, market share, brand identity (or name recognition), and optimal business size, are important across industries. In the case of building a strong management team, small business owners often have difficulty in giving up control of the organization and may not believe that anyone else can manage it as well as they have. Unfortunately, the outcome may be that they fail to develop a seasoned, independent management team. Buyers want to know that leadership and management can be effectively transitioned so that the future value of the business is not dependent on the current owner remaining with the company. This can best be accomplished by developing a management team with a depth and breadth of experience, one that is recognizable to referral sources and capable of running the business. Even with a good management team, the owner's willingness to stay with the business during a transition period may impact valuation. The transition time will vary with buyers, reflecting their expertise and infrastructure, but is typically about a year.

Development of brand identity is increasingly important in business. Brand identity is the result of perception of a business' core competencies, quality of care, mission and values, community involvement, visibility of key people in the community, rewards, recognition, etc. Additionally in a home care service business, brand equity results from formal accreditation, state survey results, and customer and physician satisfaction surveys. A strong brand identity results in market leadership including more referrals, revenues and market share for the organization.

Also, the appropriate use of technology is indirectly rewarded because it results in strong financial metrics. For instance, a home health agency that uses point-of-care or scanning technology to reduce the cycle for OASIS data collection and billing may have a shorter DSO than a traditional paper based system. An agency that utilizes remote monitoring devices and reduces nursing visits while maintaining quality indicators may show a healthier profit margin, which is rewarded in valuation, and may alleviate some business issues related to the nationwide nursing shortage.

Given the reality that completing one large deal is substantially easier than completing many small ones and then effectively integrating them, buyers also reward size when making acquisitions. A business with $30 million in annual revenues will command a higher multiple than one with $5 million in annual revenues.

Reduction of Risk

As stated earlier, the fair market value of a company is based, in part, on the risk associated with its acquisition. Many of the valuation factors already reviewed are risk related, but there are others. Owners cannot control many risk factors associated with a particular industry, such as the legal and reimbursement climate and market dynamics, but there are factors that are least marginally within the owner's control that do impact valuation. In addition to managing financial, clinical and operational metrics, owners can reduce risk through optimal product mix such as the ratio of certified home health services to State funded programs. Due to State budget shortfalls and the need to manage their budgets, many States are facing a financial crisis and reconsidering reduction in services/reimbursement and increasing thresholds to qualify for services. Currently, the higher the mix of State funded revenue, the higher the risk associated with acquisition of an agency. Managing business mix to maximize valuation means holding the line on the percent of State funded business.

Buyers also evaluate the stability of a referral base when examining risk factors. The more diverse and less dependent on a relationship with the owner (or other key employees), the more valuable the referral base becomes. Ideally, no single referral source should represent more than 10% to 15% of your referrals.

Opportunity for Growth

The buyer's perceived opportunity for expansion and revenue growth of the agency is also very important. There are two types of growth opportunities worth noting. While the potential to open new markets or to offer new product lines may increase a buyer's interest in the company, as they represent un-realized, and more importantly, un-implemented potential, the impact on valuation will be minimal. However, if new programs, products, or locations have been launched prior to a sale, and the results are beginning to trickle in, buyers are more likely to value, and hence quantify these opportunities in the form of purchase price increments. As such, sellers should analyze and explain where opportunities exist for a buyer to maximize their investment.

Increasing Deal Value For Seller

We've examined factors that impact valuation and last, but not least, managing the deal structure. Two deals that appear similar on the surface may be vastly different when corporate structure, tax consequences (combined federal and state taxes can be in excess of 40% of sale proceeds), contingent payments, guarantees, warranties, assets and liabilities assumed, purchase price allocation and note structures are evaluated and also, whether the deal is structured as an asset purchase the amount of money the owner ultimately puts in the bank. If the owner has a planned exit strategy, some of the preparation for deal structure will already be done. For instance, an owner may choose to execute an S-Corporation election during start-up to reduce the taxes that will be paid during the sale.

The type of sale, either asset or stock, has multiple implications for both the buyer and seller. Unfortunately, what is best for one is not necessarily best for the other and can become a point of contention during negotiations. In an asset purchase -- the most common type of sale for smaller businesses -- the buyer can purchase all of the assets on the balance sheet (plus intangibles) or only selected assets. Buyers usually prefer asset transactions in order to attempt to avoid the assumption of unknown liabilities - most notably liabilities relating to compliance issues, billing error or fraud. In a stock purchase, however, the buyer purchases the stock of a corporation, rather than individual assets, and therefore also acquires the corporation itself and all the unknown liabilities that go with it. In the asset based transaction, the seller's corporate status (S vs C) can make a huge difference in after-tax proceeds. For an S Corporation, the profits from the sale flow directly to the individual shareholder and are taxed at the personal income tax level. But, a seller with a C corporation faces a very different situation. With an asset transaction, the proceeds of the sale are paid to the corporation, which is first taxed at the corporate level. When the sale proceeds are eventually distributed to shareholders, generally in the form of dividends, they pay taxes again on the distribution at the personal level. This "double taxation" can be so onerous, that from a practical matter, it is extremely rare for C corp sellers to entertain asset transactions. Thus, leaving the sale of stock the only viable alternative, where, shareholders, and not the company, sell their stock in the firm, a sale that is taxed only once at the personal income tax level.

Unfortunately, as stated before, buyers abhor stock transactions due to the assumption of unknown liabilities. Since it takes a number of years to fully benefit from a change from C to S corp status (the IRS is wise to that strategy), it is incumbent on sellers of C corps to (a) find buyers willing to consider the acquisition of stock, (b) make sure their firms are as pure as the driven snow, (c) be prepared to have a portion of the purchase price placed in escrow to secure unknown liabilities, and (d) be prepared to offer complete, unlimited, indemnification to the buyer for any past wrongdoings.

In this brief and simplistic analysis, the significant impact of deal structure is apparent. The right deal structure can maximize value, while minimizing risk and tax consequences.

Conclusion

Selling a business is one of the biggest decisions the average person will ever make because it represents their family's future financial security. Although planning an exit strategy may be low on the list of priorities, paying attention now to how you will transition business ownership in the future will provide great rewards. Planning a strategy to grow your business for maximum valuation means reducing risk through strong financials, a seasoned management team, diverse referral base, optimal business mix, and a strong brand identity. When the time comes to sell, solid deal structure and tax planning will maximize seller value. In consultation with professional M&A advisors, you can realize your dream of a smooth and financially rewarding business transaction.