“I’ll have a cheeseburger and a Diet Coke, please” I said to the 27- month- old waitress.

“Cheeseburger and Diet Coke,” she confirmed back to me as she toddled off behind the kitchen counter.

Ten seconds later she was back with my imaginary lunch.

“How much money does that cost?” I asked.

“Twenty dollars, Papa,” she replied, pausing. “No,” she said, as if to correct herself, “twenty and a half dollars.”

“Twenty and a half?” I exclaimed, feigning incredulity. “What if I give you five dollars?”

“Five dollars,” she acknowledged, taking the proffered fake cash. “I put it in the register.”

Then with a little prompting by her mother, “Thank you very much.”

We start ’em young in the Howe Family. Nothing like having a captive (and captivated) audience of grandparents, aunts, and uncles to get the youngest generation going while we all waited for Uncle Chuck to produce the real burgers on the new gas grill last weekend.

Of course, there’s only so far that you can take a lesson on value creation when you’re dealing with a toddler. Learning “please” and “thank you” is much more important at this stage than discriminating between a five- and a twenty-dollar burger. But the expected closing of my third major client buy-out in the past three years reminds me once again that valuation at all levels most often boils down to a calculation of the buyer’s expected financial return.

As the negotiations developed during the past few months with my client, the key factors in the buy-out equation were these:

1. It’s a financial acquisition – This buyer’s primary objective is a strong financial return. This is not a strategic purchase where synergies or complementary products will create overall savings and enhance the bottom line.

2. Profitability – The target (my client) has an eight-year track record of increasing sales (with a minor gap in 2009), increasing margins, and increasing profits.

3. Industry position – The Company’s proprietary advantage is its position as a favored supplier to its main customer, which is the industry leader.

4. Leadership – The new investors are acquiring an experienced management team, the critical members of which have been offered appropriate incentives to stay on board and build further value.

5. Predictability – These four elements in combination allow the acquirers to have confidence in projecting a financial return consistent with their 20%+ ROI objectives.

On the flip side of the coin, I have in recent years counseled a number of $5-15 million (annual revenue) service companies whose owners initially felt that their top line should be the primary driver of value. They hear of competitors selling for a multiple of revenue, and they in many cases fail to recognize that the multiplier is simply shorthand for expressing the purchase price. The fact that it’s not a cause-and-effect relationship, revenue to value, eludes them.

As we work together, these companies begin to understand the true determinants of value. At the risk of my condensing what can be a complex process, buyers are attracted by:

1. High profit percentage – A highly successful service business that brings one-third of its revenue to the bottom line, pre-tax (after subtracting one-third for direct costs and one-third for Selling, General, & Administrative expenses), will have a strong argument for a value of two times revenue, which will produce an attractive ROI of 16.7%. The more typically marketable service company, well-run with a 15% bottom line, might be surprised to realize that achieving the face-value threshold of many small business investors – a 15% ROI – results in a valuation of just one times revenue.

2. Recurring revenue – The service company which enters each fiscal year with more than half its annual revenue assured by long-term agreements and/or unique corporate (not personal) relationships has high intrinsic value vs. the competitor that starts out with an empty book.

3. Salaries vs. profits – Potential buyers of companies want to see an income statement that reflects the true cost of operating the business, one that shows the owner’s salary in terms of his or her replacement cost as a manager, stripped of the perks of ownership.

4. Redundant, institutionalized knowledge – If the company’s proprietary position is vested in just a small group of employees, they all become de facto owners. Whether intended or not, they thus become party to your acquisition negotiations. Better that the firm’s capabilities and its client relationships be spread among many staff members.

5. The owner’s continuing involvement – In M & A parlance, this is known as an earn-out: the buyer wants to ensure both a smooth transfer of your “success formula” as well as your enduring loyalty. So forget about cashing out upon closing the deal; you’ll leave a lot on the table unless you stay in the game for a while.

Abby stayed in the game last weekend, right until her Aunt Beth turned the tables…

Beth: Here, Abby. I have a milkshake that I’ll sell you for five dollars.

Abby: Here’s five dollars.

Beth: And here’s your milkshake. Now what are you going to do with it?

Abby: Put it in the register.

Clearly there’s a need here for further concept development.

Alligator Bites

“Our sales had grown steadily since 2005; by 2008 we were doing more than $1 billion in gross merchandise sales [of shoes and apparel online] annually – two years ahead of our original plan. We were now profitable, and our culture was even stronger. As before, our plan was to stay independent and eventually go public.

“But our board of directors had other ideas…the recession and the credit crisis had put Zappos – and our investors – in a very precarious position.

“These issues [of inventory valuation and bank financing] had nothing to do with the underlying performance of our business, but they increased tensions on our board…Some board members had always viewed our company culture as a pet project – “Tony’s social experiments,” they called it. I disagreed. I believe that getting the culture right is the most important thing a company can do. But the board took the conventional view – namely, that a business should focus on profitability first and then use the profits to do nice things for its employees. The board’s attitude was that my “social experiments” might make for good PR but that they didn’t move the overall business forward. The board wanted me, or whoever was CEO, to spend less time on worrying about employee happiness and more time selling shoes…”

– from Delivering Happiness: A Path to Profits, Passion, and Purpose by Tony Hsieh, excerpted in Inc. magazine, June, 2010

Hsieh is founder and CEO of Zappos, acquired by Amazon for $1.2 billion in November, 2009

Draining the Swamp

EBITDA is earnings before interest, taxes, depreciation, and amortization. It measures a company’s financial performance by computing earnings from core business operations, without including the effects of capital structure, tax rates, and depreciation policies. It is used as a proxy for a company’s operating cash flow and is not defined under GAAP [Generally Accepted Accounting Policies]. EBITDA is often used to value a company, with the enterprise value of a company calculated as a multiple of its EBITDA.

– from Wiki CFO, A LinkedIn Group