Keeping Your Valuation High by Keeping the Risks to Acquirers Low, Key #1: Earnings Risk
Paul opens a series on how risk drives valuation multiples, starting with earnings risk: earnings trends, validating EBITDA adjustments, accounting consistency, and setting a working capital target.
Full transcript
Generated from the episode audio and lightly edited for readability.
Good morning and welcome to another episode of Paul Martin's Guide to finishing well. Today we are going to turn to a new series. We have been speaking in the last few weeks about how to drive your IPA. And what we're going to turn to now is another major element of value which is how to reduce your risks. Let's jump in. So as we look at valuation in the rehabilitation industry and how acquirers are valing valuing rehabilitation businesses really comes down to that EBITDA your earnings before interest taxes and depreciation and amateurization times a multiple.
Well, what drives that multiple up or down? It really all comes down to the risk. Well, where is that risk inherent? Where do we find that risk? Because typically that risk does not come out as something that's very simple to see from the surface. We really have to dig in to find that risk. And it's inherent in five major categories. The first of those categories is earnings risk. And you notice that earnings risk we have here bold and in red. That is the primary risk factor that the other risk factors impact.
So we also have referral and payer risk. We have people risk. We have market risk. And finally we have compliant risk. Well, how does risk in those five categories that we just described? How does risk impact valuation? It comes down to this. The higher the risk inherent in those five categories, all which lead up to your earnings, the lower the multiple. The lower the risk, the higher the multiple. And why is that? Because acquirers are utilizing other people's money. Okay, we call it OPM. They're utilizing private equity group.
The private equity group is utilizing a lot of bank financing. And they are going to have to pay back that money. And where are they going to get that from? They're going to get that from the earnings that they have acquired from you and the ability of that earnings to continue to grow over time. So that's why earnings risk is at the top of the risk factors and that's what we're going to focus and hone in on today. How do we reduce the risk of your earnings?
Remember, earnings is what pays back the other people that they are borrowing from. All right? So, earnings risk. You know, when you look at an acquirer and what they're purchasing, yes, they're purchasing your referral base. Yes, they're purchasing the relationships in which you have built. But again, what we're talking about is driving their ability to pay higher and higher multiples. That comes down to your earnings. They're buying a stream of cash flow today and that same stream of cash flow going forward. So, what's very important about those earnings are the trends of those earnings.
Are your earnings trending positively or are they trending negatively? And an analysis of that is really important as we look at how to prepare for a transition or a sale of your company. What is driving the EBITDA or your cash flow? Is it coming from other sources of income other than very traditional physical therapy products? Because that's really important on how an acquirer will view that earnings and the risk inherent in those earnings. You know, in addition as it relates to earnings, this is a big focus of the due diligence that the acquirers are doing.
And these are highlevel financial folks that are doing this due diligence. And that examination is going to first and foremost identify and validate adjustments to the EBITDA. Many folks out there call these the adbacks. Okay. And it's imperatively important that as we look at those adjustments that have been made to EBITDA that you can be very clear on what those are and why those will not be things that will be a part of the business going forward. Those are those adjustments and it we have to be able to validate those.
We need to address any and all accounting issues. So what are some of the accounting methodologies that you are utilizing and are they consistent with what the acquirers are utilizing? Really really important. We need to establish a working capital target. This all comes from your financials which includes your profit and loss statement and your balance sheet. Typically, the working capital is what an acquirer is looking to have in within your company moving forward. So, they don't have to put money into your business after they've acquired your business for the first couple months after they've acquired.
Typically, these businesses are acquired when what we call debtree, so you keep all your debt, and cash free, so you're going to keep all your cash. But they are also acquired with a certain level of working capital which in most cases is going to come from either all or a portion of your accounts receivable. So this is definitely a financial examination in establishing what that working capital target will need to be going forward. All right. So, we've talked a lot about how you can prepare, but what are the three things that you should take from this episode and do today?
Start today. Well, first is you really need to have an earnings story. And what I mean by that is looking at the most important period of time for an acquirer is what we call trailing 12 months. That's the 12 months prior to the look at the business, the valuation of the business, and what were your earnings for that period. But we have to go back and look previously at other periods going back to allow you to create that story. Have your earnings been driving forward or have they been declining?
And on both sides, why and how? Really, really important to have that story prepared for an acquirer. We need to have bulletproof numbers, okay? And that really comes down to an accounting review prior to taking your business into the market. This is all a part of preparation. Now, for a small business, that could be basically your accountant who has compiled your financial information. Maybe they do that monthly, quarterly, maybe it's annually. We certainly advise that to be done monthly and back a few years. The next level would be reviewed, a review of your financial information.
And then the third level of that would be an audit. And for companies over a million and a half, two million of IPA, we typically recommend to go through an audit because you have to have bulletproof numbers. This is what the acquirer is buying. And then finally, while an acquirer is buying your current earnings, what they're really buying is that current earnings and moving forward that cash flow moving forward into the future. They're buying your future earnings. And again, that's how they're going to pay back their debtors, the banks, as well as that private equity group.
So the earnings journey going forward is absolutely important in order to show that acquirer where are your earnings headed in the future and why? What are your growth strategies? What are your growth plans? What are things that you just started? And putting that into a very succinct journey on your earnings going forward is huge as it relates to valuation. So if you today are thinking about moving your company, transitioning your company into the market, trying to find a larger partner in a sale of your company, and you want to talk about that earnings risk and how we can reduce that earnings risk in order to increase the multiple that will be paid for your company, click below and let's talk. I look forward to talking to you.
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