Five Common Misconceptions when Valuing and ARM Company
A day rarely goes by that I am not talking to someone about pricing an accounts receivable management (ARM) firm. At a conference, I could have a dozen conversations about this important topic. Owners and investors alike want to understand the value of the business they own or the one they are contemplating acquiring. That makes sense since a company is typically the most valuable asset that a family owns and an investment firm does not want to overpay for an acquisition. After more than a quarter century and at least 10,000 pricing discussions, I want to dispel the five most common misconceptions that have been formed when it comes to valuing an ARM company.
Misconception #1 – I am the owner and CEO of my company and my compensation should be added back fully.
You are in the majority if you believe that the entire amount that you are paying yourself, net of distributions in a year, should be completely added back to that year’s net income to properly reflect the true earnings of your business. In essence, you’re stating that you serve absolutely no function of value whatsoever within your own company. Here are some simple questions to ask yourself if you’re one of the owners that think you’re adding zero value to your business:
Whose name is on the bank accounts?
Who do your clients or top managers call when the s – – t hits the fan?
Who can’t sleep when a major lawsuit is filed against your business or the CFPB decides to conduct an investigation?
Who is the visionary for your business?
When was the last time you walked into your business?
If the answer to the first 4 questions is you, then you probably add some value to your business that needs to be accounted for. If the answer to question 5 is every day, but only to look at the numbers, your compensation should not be added back fully. Unless you’re an owner who, as an owner, completely removed him/herself from all responsibilities associated with the business, or you are a part of an investment company that is charging management fees but not serving any operational function for the business, the truth is some amount needs to be added back to cover the costs associated with replacing you.
Misconception #2 – I own a commercial collection agency and my judgments should be valued as a separate asset.
If the judgments don’t appear on your balance sheet as an asset, they will not be treated as a separate asset. Instead, a business buyer typically views judgments as a key indicator that your company will continue to generate revenue into the future, even if you lose clients or placement volumes drop. They will not assign a separate value to judgments. Of course, if you don’t replace client losses, the revenue stream will drop over time as the judgments are collected. Client loses will negatively impact pricing.
Misconception #3 – There is a rule-of-thumb used to price an ARM company.
Over the years, I am sure I heard all of the rules-of-thumb that owners believe are being used to value their business. One time annual fees. Three to five times monthly collections. Five times earnings, to list a few. Let me set the record straight. There are no hard-set rules-of-thumb when it comes to valuing a debt collection agency. Value is determined based upon the individual merits of the business being evaluated including, but not limited to, the following factors:
Historical, current and projected financial performance;
Operational components including clients served, services provided, leadership team and technological platform to name a few;
Macro-market and economic conditions;
Anticipated capital expenditures; and
The business’ potential exposure from lawsuits and/or regulators.
If you want to truly understand the value of your business asset, you may want to confidentially talk to an owner who recently sold his or her business.
Misconception #4 – Our business was highly profitable in the past, and will be profitable again in the future, so we should be valued at the same level we were valued previously.
Sounds ridiculous when you read it, right? Truthfully, I have this conversation quite often. Let me give you an example. Fictional business ABC provided ARM services to large financial institutions for years. The business grew profitably as they added new clients and new business from existing clients. The business eventually leveled off and started losing business due to industry dynamics. Some of their clients started selling a portion of their A/R to debt buyers which reduced the amount of new placements the ARM company was receiving. Even though revenues and profits dropped considerably, the owner believed the value of her business should be based upon historical performance because, she believed, the business would start to service the debt buyers and make up the short fall.
Buyers will typically value a service business like an ARM company based upon its most recent financial performance, factoring in historical results and projected outcomes. If a buyer is looking at a company in the middle of a year, they will most likely want to review the trailing-twelve-months’ P&L statement and compare it to similar periods, at least two years in the past.
Misconception #5 – All of the lawsuits against our firm are frivolous and should not impact our valuation.
Lawsuits are an indicator of future performance. Have the number of lawsuits levied against your firm by consumers increased? Have the settlement amounts also increased? Do any of the suits have the potential of escalating to class action status? Have your company’s legal expenses associated with settling and litigating claims against your firm escalated? How has your E&O insurance been impacted? Buyers will closely scrutinize all of the pending lawsuits, and compare them to historical claims against your firm to determine whether they believe the suits are frivolous or valid claims. In today’s litigious society, buyers don’t want to be left accountable for historical events and will adjust pricing, or the structure of the transaction, to account for their concerns.
These are the five most common misconceptions that have been formed when it comes to valuing an ARM company. As I stated earlier, a buyer will determine value based upon the individual merits of the business being evaluated. Knowing the common misconceptions is a good starting point when contemplating your own firm’s value. Having an expert valuation firm with extensive experience in ARM assess the value of your business is an appropriate next step.