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Thursday, June 9, 2011

Dr. Seuss and the Valuation Of Small Firms

by Smyth Performance on Wednesday, April 13, 2011 at 11:01am
I have talked openly about the learnings I am aquiring as I go through the process of simplifying my Factory Five related companies and the issue of valuation is center stage.  Before going on here it is time for a little disclaimer:  In the following general discussion I am not talking about any specific deal or transaction....these are all thoughts on what I have seen to date over my 15 years in the car business.  Please don't infer anything regarding the current operations of Smyth Performance, FFR, or Local motors in this discussion.

So where were we...right, valuation of the small manufacturing company post world financial crisis.

Before the economic crisis...back when you could get a loan for just about anything, it was possible to borrow and buy a good small company.  Earnings were good to great, growth was pretty steady if you ran a well managed company, and people were not getting much in the way of returns in the stock market or money funds.  A pretty nice environment for investing in the purchase of small companies.  After the great credit freeze(that we are still in by the way) how do you buy or sell?  For a year or two survival and profitability were your goal.  Just keeping the banks from calling a line of credit was a win for most of 2009 for most firms.  And now you want to sell?

The answer doesn't have much to do with credit as it does valuation.  How do you value a company if the firm has had a couple of years with poor financials...let alone one that didn't react to the economic realities of the last few years and has a train wreck for a balance sheet.  The usual 3-5 times earnings or some multiple formula won't work....good luck getting a business owner who knows she has a good basic business model to sell for 3x 2009-2011 profits.  Assets?  He/she probably used most of their liquidity to survive if they didn't reduce overhead fast enough in 2009....Even if management did a great job during the last two years and protected the core business from an asset drain, the top line suffered double digit losses of revenue.  If you kept your profits in tact you did a good job...but it cost you in human capital and skills that left the company.  All those people that were laid off represent a massive investment in training and skills.  So how do you sell?  You really don't.

A buddy of mine in the Ferrari business told me a year ago that all the guys who HAD to sell had sold...prices for vintage ferraris were solid again since the fire sale was over.  Most of these wealthy clients knew they would be wealthy again and just buy another car they sold at half what the cars were worth, cash was king.  The prices are still down for most expensive toys like boats and ferraris but nothing like 2009.  I was glad to hear this since I have been making plans for the growth of Smyth performance and my source of funding is in the garage.  It takes 50 grand to start an ice cream stand, how much do you think it costs to start an auto related manufacturing business?  Five kids with number one heading to college next year makes you a pretty conservative guy... two years ago the toys were about to be loans for smyth is still king.  A 69 dodge 440 charger and a couple of ferraris makes for a nice launch fund...I will raise capital if I need it next year after showing a nice year of sales for the launch of the smyth car.

The reason I bring this up is that selling a business is no different.  If you absolutely HAVE to sell you are in the same boat as the fire sale guys were after the melt down...they sold $200,000 vintage ferraris for 80 grand.  If you run a small business you are fully aware that even companies that have never missed a payment on their credit line can not get money from the line that was probably frozen in 2009.  Banks are still hesitant to loan the buyer of a business money since they inevitably use the profits looking rearward to support the loan.  If you have a large pool of assets you can use that I guess, but any business worth having has stable cash flow and/or growth....commodities that are few and far between in the small business community from 2008 to 2010.

The buyer and seller dealing in good faith are forced to look at predicted future cash flow since the rear view mirror doesn't reflect reality and both know it.  If you try to use the last two years as a guide to valuation the doors to the company you are looking at will be slammed in your face.  It can work if both buyer and seller understand and believe in the business...the deals that are getting done seem to rely heavily on payouts of future earnings which fits the model I describe here.  More than likely even these deals will be shelved for a few years until the financials can be fixed with real profits from the leaner and more efficient operations most of us were forced to adopt...the sunny side if there is one. Then we will all sign on the deals with solid numbers and a good business environment...I doubt banks will be as big a part in these transactions as they used to be, but I think the sale can be made.

In the mean time the situation is analogous to a worker getting a job in another state and not being able to move.  If his/her house is upside down loan wise, how can they move to a new town?  In both cases you have to wait it out.  Most people are not good at waiting.  In my world I am trapped in the same situation as I try to consolidate the factory five related entities and prepare for my exit.  Real estate trusts, licensing companies, holding companies, all support the factory five mini empire in a needlessly complex way.  This will change over these next years as I work to simplify the organization into a sale-able unit.  Whether my brother Dave buys my half of the various companies or not, they will be streamlined and an easier asset to value and sell. It is quite a dilemma that is probably shared by any closely held company owner.  In a normal world Dave would have been able to buy the whole thing by now and I would have been solely focused on diesels and writing about home built cars in a cool little book.

In our new universe we move forward as if we sold the place even though I still own half....a little strange but it will work well if I continue to have the discipline to stay out of their way.  I spend my time building the Smyth "green" perforamance brand while Dave can be free to take FFR where he wants to...hopefully on a multi year growth and profit  rebound.  In a few years the reward for his hard work is a shot at owning the whole place.  All good if we maintain some balance and execute to plan. We all want FFR and Smyth to succeed and continue to dominate their unique product niches.

As these notes are a work in progress,I will sign off with advice from the Dr. Seuss book "Oh! The Places You'll Go! "  There is a great two page spread that describes the "waiting place".  Sometimes we all get stuck there.  My advice to any small business owner is to know when you are in the waiting place and make a good plan to get to the next may even take some time...but get to it.  Dr. Seuss...Read the book...a great business read if you ask me.

Mark Smith

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