For Sale?

As I write this article, many base metal prices have hit or are nearing new multi-year, if not all-time, highs. For most companies, revenue growth has been driven more by price increases than by volume. Business owners have to ask themselves if the growth of their companies is truly because of successful operating dynamics or merely a factor of increased commodity prices. This is the key question that buyers of metal-based businesses are asking as they consider acquisitions.

The objective of this article is to ensure that readers understand that several considerations will affect their businesses’ values and to encourage prospective sellers to put as much effort into the selling process as they have into their companies’ operations. After all, the average selling process lasts about one year, but when executed correctly, it can yield as much as the total cumulative earnings that the owner has made over the life of his or her company.

THINKING AHEAD. If you are considering selling your company, be sure to have documentation breaking down revenue for the last three years by the volume of each grade of metal that you sell. With this information, the perspective buyer will be able to analyze if you have been growing faster or slower than the market, which is a key parameter in determining the value of your company. Red flags go up for businesses that have only grown proportionally to or less than the increase in the underlying base metal price increases.

The most common resistance from prospective buyers that we hear in today’s market is, "It is the peak of the market." Knowing this, buyers are very wary of acquiring companies that have merely "ridden the price wave."

These days, owners of metals-based businesses should be asking themselves if they are invested in the commodities market or in running a metals-based business. If the answer is the former, beware, as good times don’t last forever. Maybe it is time to sell.

Additionally, now that merger and acquisition activity is high, it is essential for owners to understand the factors that are relevant to their companies’ values.

ANALYZING THE NUMBERS. Most sellers do little in the way of homework prior to meeting with mergers and acquisitions (M&A) professionals aside from asking their accountants if it is a good time to sell and what they can expect to get for their companies.

Because many accountants’ expertise is in corporate taxation, as opposed to transactions, they provide generic answers to this relatively complex question. The most common answer to the valuation question is four to six times normalized earnings before income, taxes, depreciation and amortization (EBITDA).

This answer is helpful for most small companies with good historical performance and strong growth prospects. However, commodities-based businesses that have low value-added components, such as metal recyclers and producers, are valued differently.

The following factors should be taken into account when valuating small metal-based companies:

1. Multiples of metal based businesses trade at a substantially lower multiple than most other industries—Based upon our research, the average EBITDA multiple of large publicly traded non-metals companies with strong liquidity is from 13 to 15. However, the average multiple for a selection of companies in metal recycling and production is about 6.1.

2. Small businesses have much more company-specific risk than larger companies—Discount rates, used to value businesses, have a "company-specific risk factor." As risk increases, so does the discount rate, resulting in lower values.

3. Lack of liquidity vs. publicly traded corporations—Increased liquidity is directly proportional to valuation multiples. That is the major reason why companies go public.

4. Because of No. 2 and No. 3, small private companies (with similar growth potential within the same markets) trade at lower multiples (25 percent to 50 percent is common) of that of large publicly traded companies.

In addition to these factors, when valuating a metals recycling business, a number of common value deflators should also be avoided.

COMMON VALUE DEFLATORS. Sellers should avoid these common value deflators:

1. Limiting negotiations to one buyer—Most merger and acquisition professionals have access to industry sales data from around the country with a sample size in the hundreds or thousands, yet they still will perform a detailed valuation prior to an offering. The high end of the valuation range can be as much as double the low end (i.e. $10 million to $20 million) with a common range being about 50 percent that of the low-end estimate (i.e. $10 million to $15 million).

Why is the range so large? The potential strategic buyer pool is diverse with a large range of synergies or the company’s growth opportunities are difficult to forecast.

The fact is, one can do all the valuations in the world, but ultimately the company will be worth what the market is willing to pay. The only real way of knowing what the market will pay is to secure multiple bids and play them against each other. We have a saying in the industry: "One bidder is no bidder, he is a dictator."

2. Inappropriate entity structure—A relatively high percentage of companies in the metal industry are incorporated as C corporations. Many of these businesses were incorporated 20 to 30 years ago when limited liability corporations (LLCs) did not exist or were unpopular and Subchapter S corporations had other disadvantages. Most of these companies have no reason to be a C corporation today.

When selling their businesses, most owners of small C corporations will pay double the tax that they would have paid were they an LLC or Subchapter S corporation. That’s because regular corporations and their shareholders are subject to a double tax (the corporation and the shareholders are taxed on an asset sale) on the increased value of the property/business when it is sold or liquidated.

By contrast, LLC owners and Subchapter S corporations avoid this double taxation on a sale of assets because the business’s tax liabilities are passed through them; the LLC or S corporation does not pay a tax on its income.

A common misconception is that you can avoid double taxation by merely converting to a Subchapter S. When an existing C corporation converts to an S corporation, only the post-conversion appreciation in the corporation’s assets will qualify for single level tax treatment, unless the corporation’s assets are sold more than 10 years after the date of conversion.

3. Transferability concerns—Transferability challenges are usually a result of two issues: Substantial intellectual property is in the owner’s head or the owner has a large number of close relationships that are at risk when he or she leaves the company.

Many metals businesses pride themselves on maintaining close relationships with key customers and vendors. Even when the company has grown to a substantial size, often the owner still acts as the "customer liaison."

If that sounds familiar, ask yourself which customers will leave when you leave. If the answer feels uncomfortable, then consider removing yourself from the business. Although your payroll will probably go up, the value you get from this move should be several times more than the payroll increase.4. Poor or no professional representation—As the metals industry consolidates, several large corporations are emerging in just about every sector. The dominant players are often aggressive acquirers and can often justify higher valuations. In addition, hundreds of private equity groups (PEGs) are rolling up small players. If you want to get the best price for your business, you need to get exposure to either or both the large players and PEGs.

Most people are familiar with the Latin phrase, Caveat emptor, "Let the buyer beware." But few can tell you how to say, "Let the seller beware." The law focuses on the buyer because it is assumed that the typical buyer needs protection. However, with M&A transactions, it is generally the seller that needs protection because the buyer usually has substantially more expertise in valuing and negotiating for companies than the seller.

When it comes time to sell your company, it is imperative that you have strong representation protecting your interests. This does not mean your local business broker, your CPA or long-time corporate attorney friend.

I advise you to inquire as to the extent of transactional experience that your CPA and attorney have.

The key word here is "transactional." Many accountants are tax preparers who do not specialize in deal structuring. Likewise with attorneys; transactional expertise is a specialty within corporate law. Don’t take it for granted; it can cost you millions.

TIMING IT RIGHT. Finally, as the saying goes, "Timing is everything." An understanding of your business opportunities as well as industry and economic dynamics is essential in determining when values will be highest.