The Art and Science Of Valuation Part 2
Welcome back to the Mid Market Insider!
Let’s jump in…
This week I want to get back to the valuation deep dive. In particular, we will dive into how various assets are treated during a sale.
There are 3 classes of assets that get special treatment:
1. Working capital
2. Real Estate
3. Non-operating assets
Let’s break them down one by one.
1. Working Capital
(The amount of capital required to run the business.)
Working capital is a complex issue to discuss and one that seems to annoy sellers the most.
Now I won’t bore you with a whole paragraph breaking down working capital itself.
(We can save that for another issue)
Instead what I want to do is focus on how it impacts the valuation of lower middle market companies.
This is one critical element that often gets overlooked.
In the lower middle market, any valuation will include sufficient working capital to run the business.
Think of it as the fuel that keeps the engine running.
Here's why it matters: Imagine you're eyeing a $25 million acquisition.
The target company's performance looks stellar, but there's a catch. Without sufficient working capital, additional investment would be required in order to maintain historical cash flows.
Even with identical EBITDA margins, you'd need to inject additional capital just to maintain operations.
The math is simple. A $25 million price tag without working capital effectively becomes, for example, a $28 million investment once you factor in the necessary capital injection.
That's why buyers insist on including working capital in the purchase price – it's not just about buying the engine, but also ensuring there's enough fuel in the tank to keep it running at peak performance.
Now let’s explore how the working capital mechanism works close to close.
First, a working capital peg will be established based on some method that has been agreed to by both parties.
Let’s say the working capital peg is $1 million and four weeks after the close both parties agree that the working capital was $1.2 million then the buyers would have to compensate the sellers for that difference.
Similarly, if the working capital was less than the peg, sellers need to compensate the buyers for any shortfall.
2. Real Estate
Generally speaking, financial buyers are more interested in operating assets than non-operating assets i.e. real estate.
Now if you are a seller looking to include the real estate in the deal then most buyers would accommodate that as it’s easy to sell.
Smart business owners know the value of separating real estate from operations. When a property is owned by the business or a related entity, treat it as its own venture. This means the operating company becomes a tenant, with standard expenses like rent and property taxes flowing through its income statement.
I would encourage sellers to work with commercial real estate agents to determine what a fair market rent would be and also to get an up-to-date appraisal.
You could even explore a sales leaseback transaction i.e. you sell the real estate to the buyer and you lease the property back from the entity or group.
3. Non-Operating Assets
This one is the most straightforward. Whenever a buyer asks what assets are included in the purchase, strip out any personal vehicles, furniture, etc. that you don’t want to be included in the sale.
However, it is important to note you have to prove that they are used in a personal nature and not required in the business.
After all this talk of working capital, real estate, and other assets, here's what matters: successful deals come down to smart preparation. Understanding these different nuances can help you maximize value.
And remember a successful transaction isn't just about the headline price - it's about structuring a deal that works for both parties while ensuring the business can thrive post-sale.
Whether you're buying or selling, I hope (if you have made it this far) that this will help you navigate the complexities of the lower middle market.
I know that was a lot, but if you want to learn more, check out my YouTube video here.
The Lessons:
The Truth About AR in Deal Structure: Some business owners think that they should be able to keep AR since that revenue was earned under current ownership. Unfortunately, for lower middle market businesses it doesn’t commonly work that way.
Real Estate Flexibility Matters: Separating real estate from business operations creates strategic advantages. It simplifies valuation, provides flexibility in sales, and allows for cleaner financial statements. Getting current appraisals and market rent assessments strengthens your negotiating position.
Purchase Price Reality Check: A business's true purchase price includes working capital requirements. A $25M acquisition could actually cost $28M when accounting for necessary working capital, making it essential to factor this into initial valuations and negotiations.
📅 Next Week:
In next week's newsletter, we will explore the power of strategic thinking through the remarkable success story of Southwest Airlines.
Keep building,
Nick
P.S.
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