16.15 > 17.30 Workshop 1

Valuation of SMEs: how to take up the challenge?

Valuation of SME’s in The Netherlands Michel van Bremen

Partner, First Dutch Capital

The Netherlands

Trends in valuation of SME’s in The Netherlands

1.Using Adjusted Present Value method aboveDiscounted Cash Flow method

2.Growing uncertainty about cost of capital in a volatilemarket

3.High awareness of existence of fair market value

4.Growing demand for more market based approach ofvaluation

1. Valuation methods – adjusted present value

Variant on discounted cash flow method

The APV method is more flexible and can be used in case ofchanging capital structures and carry back and forwards

APV assumes 100% equity financing, subsequently the valueof other capital structure components is calculated

2. Valuation methods – cost of capital

Including small firm premium

Dependent on active sector (bèta)

Is the current risk free rate reliable to use in cost of capital calculation?

3. High awareness of existence of fair market value

Legislation regulation demands for fair market value in case of

– IFRS valuation (PPA & Impairment)

– Tax matters (transfer pricing, “economic value”)

– Corporate litigation support

Shareholders are interested in fair market value of their

companies

– Difference between value and price of SME’s

– Difference in value perception between buyer and seller

Internal analysis

Cash flow planning

Determining Adjusted Present Value

Calculating trading/transaction multiples

External analysis

How do external parties value the company (Private equity, strategic buyers, banks)

Report & advice

Indicative valuation based on internal and external analysis

Advice (exit) strategy (sell / hold / buy & build);

Conclusion

Theoretical valuation

Market analysis

Valuation report

Transaction (optional)

+

=

4. Market based valuation

Thank you for attention!

16.15 > 17.30 Workshop 1

Valuation of SMEs: how to take up the challenge?

Challenges for valuation of SMEsAlexandre Streel

Senior Manager, BDO Corporate Finance Belgium

CONTENTS

Section Page

Introduction 3

Challenges for valuation

#1. Less reliance on historical financial statements 4

#2. No access to capital markets 5

#3. Illiquidity of shares 6

#4. Strong dependence on owner 7

#5. Non diversification and other risks 8

Closing thoughts 9

INTRODUCTION

– In Belgium, SMEs (less than 50 people) account for (source: Ministry of Economy, 2010):

• 97% of companies

• 41% of employment

– Commonly used valuation methods remain the same for SMEs (as for listed or larger companies)

• Income approach: Discounted Cash Flow (DCF) and Capitalization of earnings method primary approach

• Market approach: multiples frequently used as a crosscheck approach

• Asset-based approach in some specific cases

– SMEs share some unique characteristics which affect the way of estimating inputs for valuation (cash flows/earnings, discount rates…) and may affect the value of the company.

CHALLENGES FOR VALUATION

#1. LESS RELIANCE ON HISTORICAL FINANCIAL STATEMENTS

– SME characteristics

• Failure on the part of many owners to attach a cost to the time that they spend running their businesses / separation of “salaries” from “dividends”

• Intermingling of personal and business expenses (tax-driven)

• Shorter history

• Small amount of information accompanying financial statements (e.g. segment reporting)

• Capital expenditures made at greater intervals of time

– Challenge for valuation (no impact on company’s value)

• How to estimate economic levels of cash flows (DCF) or earnings (multiples)?

– Solution

• Restate (or even reconstruct) financial statements: estimate a “reasonable” salary, strip the personal expenses out…

• Look at profit margins of comparable (publicly trades) companies

CHALLENGES FOR VALUATION

#2. NO ACCESS TO CAPITAL MARKETS

– SME characteristics

• No access to capital markets no reference for market value of equity or market cost of debt

– Challenge for valuation (no impact on company’s value)

• How to estimate beta (cost of equity)?

• How to estimate cost of debt?

• How to estimate equity/debt ratio (WACC)?

– Solution

• Beta: sector-average beta, accounting beta…

• Cost of debt: recent loan agreements, synthetic rating (interest coverage ratio)…

• Equity/debt ratio (based on market values!): own estimates of the value of debt and equity (circular reasoning), sector gearing, target gearing…

CHALLENGES FOR VALUATION

#3. ILLIQUIDITY OF SHARES

– SME characteristics

• No liquid market for the shares; selling a position in a privately-held company is a more costly, uncertain, and time-consuming process than selling the stock of a publicly-traded company

– Challenge for valuation (impact on company’s value)

• How to incorporate illiquidity into the company’s value?

– Solution

• Illiquidity discount

• Highly judgmental; frequently ranging from 10% to 40% (built on various benchmark studies: restricted stocks (US), bid-ask spread, pre-IPO transactions, cost of flotation…)

• Company specific factors to be considered: size of the company, pool of potential buyers, financial strength of the company, ability to generate cash flow…

• In DCF valuations, illiquidity can be considered as well by adjusting the discount rate (by adding a risk premium for illiquid investments)

CHALLENGES FOR VALUATION

#4. STRONG DEPENDENCE ON OWNER

– SME characteristics

• In private firms, the amount of future business profits is substantially dependent on the owner’s personal involvement and knowledge, abilities and business contacts

– Challenge for valuation (impact on company’s value)

• How to incorporate this dependency/continuity risk into the company’s value?

– Solution

• “Key person” risk premium (added to the discount rate)

• Finite life of the company; terminal value based on liquidation value instead of going-concern value

• Note: private firms where owners plan for the transition to the next generation will be worth more than private firms that do not make these arrangements

CHALLENGES FOR VALUATION

#5. NON DIVERSIFICATION AND OTHER RISKS

– SME characteristics

• Non diversification of the investment; betas (CAPM model) measure only market risk based upon the assumption that the investor in the business is well diversified whilst private firm owners often invest much of their wealth in the private business and do not have the opportunity to diversify

• Other business risks are frequently strengthened in SMEs and therefore considered, case by case, by valuation practitioners: dependency on customers, dependency on suppliers, weak position in the sector, quality of management…

– Challenge for valuation (impact on company’s value)

• How to incorporate non-diversification risk as well as other specific risks into the company’s value?

– Solution

• Some theories have been developed (e.g. “total beta” by Aswath Damodaran) but, in practice, many use a rule-of-thumb model to add to the discount rate a “small firm premium”, capturing some of all the above mentioned risks

CLOSING THOUGHTS

– Even if the principles are basically the same, the valuation of SMEs is much more difficult / technical than the valuation of publicly traded or larger companies. However, time and money spent are frequently inversely proportional to the level of difficulty of the assignment.

– The most authoritative authors on valuation do not pay much attention to SMEs (no comprehensive and up-to-date literature).

– For SMEs, “public companies multiples” methods should be carefully used; SME’s characteristics (especially the ones which affect value) are difficult to enclose in one single multiple or discount.

– For SMEs, “public companies multiples” methods should be carefully used; SME’s characteristics (especially the ones which affect the company’s value) are difficult to enclose in one single multiple or discount.

Thank you for attention!

18May 2012

LESSONS LEARNED FROM A SUCCESSFUL ACQUISITION

Regional leader in Bakery equipment

Dijon, France

1-Buyer’s Background

• 46 years old (43 during acquisition process)• Former French Navy captain:

– Helicopter pilot– Exchange program during 3 years in Germany– Naval attaché to the embassy of France, Washington DC– MBA at Lyon Business school (EM Lyon)– Head of the management control department at the French Navy Staff in

Paris

• In 2009, opted for an entrepreuneurial second carreer,became member of CRA

• Contacted Celsius-Equipment with the help of CRA and madethe acquisition.• Maried to Daphné, Father of 4 children.

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2-Celsius Equipement

• Sells, installs, maintains and repairs all kinds of equipment forbakeries around Dijon (France).

•24h/24 readiness (2 teams)

•BONGARD dealer

•Sales 8: 2 400 000 €, EBIT : 100 000 €, 12 people.

•Main milestones:•First meeting with the seller: June 27

•LOI Signature: August 6th

•Protocole NOV 18

•Closing : Dec 9

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Challenge for the buyer: How to value such a business?

3-The Pragmatic approach

• The price is where offer and demand match (i.e: what the buyeris ready to pay, what the seller accepts to receive)

• For small businesses, the seller chooses the buyer. Subjectivefeelings may play a decisive part.

• A good deal is:– When the buyer can pay overtime for the acquistion loan– When the buyer can pay himself an income– When the buyer has some money remaining for re-investing

in his company

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4- The best way for a pragmatic approach

1. Build confidence with the seller. Do not talk to earlyabout price.

2. Be aware that many aspects have to be part of thenegociation beside price

3. Choose a simple methodology to have a basis onwhich to start (i.e multiple of EBIT + cash – debts)

4. Carefully prepare your argumentation

5. Do not loose time.

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5- How the deal has been made

1. Buyer has made a written offer (LOI proposal)2. Two negociaton rounds

-the profit of the year-liability guarantee-who pays what during the transition period?-How do we proceed after the transition period?

3. One more negociation before the protocole is signed

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Final considerations

SME valuation is utmost importanceSME valuation is part of a global challenge

SME valuation must not amper the whole transferprocess. It must make it easier.

• Alina Dudele - CEO, SIA "Biznesakonsultantugrupa", Latvia

• Bernd Rüegg - CEO, M+A RüeggMittelstandsberatung GmbH, Germany

• Michel van Bremen - Partner, First Dutch Capital, The Netherlands

• Alexandre Streel - Senior Manager, BDO Corporate Finance, Belgium

• Testimonial: Florent de FELCOURT - General Manager, TORTORA Celsius Equipement, France

16.15 > 17.30 Workshop 1

Valuation of SMEs: how to take up the challenge?

Coming next…

Plenary Session: 17.30 > 18.00

(Indianapolis Room)