5.1Topical Case: Enviro-Lawn Consider the following real world case that was published in Journal of Business Education, Vol. 2, Spring, 2001, pp. 2330. It is reprinted here with permission from the publisher. Introduction In need of part-time school jobs and wanting business experience, John and Andy Miller decided to start a lawn-care business as opposed to working a minimum wage student job. In February 1997, they formed an S-corporation and obtained a $13,000 loan at an interest rate of 10% from John's brother-in-law, Bill. In addition to the 10% interest, Bill received a 10% ownership stake in the firm. John contributed his old Toyota truck valued at $1,800. His wife, Sue, contributed work hours valued at $1,800, and Andy gave $500 in cash and $1,300 worth of labor. Figuring that John, Sue, and Andy contributed an equal amount, ownership was divided as follows: John and Sue together, 60%; Andy, 30%; and Bill, 10%. John was to run the business until he graduated in August of 1998. Then Andy would take over until he too finished college in April of 2000. At that point, the business would be sold or liquidated, and the proceeds would be divided to each owner based on percentage of ownership. Enviro-Lawn's first year's business activities focused on spring aeration, power raking, and lawn mowing. They even found themselves laying sod. At the end of their first season, most of their equipment was destroyed in an auto accident. The $8,000 of insurance money was used to invest in a larger lawn sprayer and to buy two used trucks. By focusing more on lawn spraying and pest-control, the business began to grow. Customer contracts further increased revenues and soon Enviro-Lawn grew from a part-time side job into a healthy small business. Now after three years of operations, Andy, who is currently running Enviro-Lawn, is graduating and wants to divest the business either through liquidation or by selling the business as a going concern. Andy is concerned, however, that he will not be able to sell the business for enough to pay off the $10,000 debt that is currently owed to Bill. Pete Williams, an acquaintance who owns a local landscape business, surprises Andy by offering him $15,000 to buy Enviro-Lawn as a going concern. Payment would be up-front and he would assume the business before the 2000 spring season, releasing Andy from any further work. This offer has caught Andy off guard. Pete's offer does not include the assumption of debt, but Andy is excited to think that he can pay off this debt and still have $5,000 to divide among the owners. After a quick calculation, Andy determines that, personally, he can walk away with $1,500 in cash and have no strings attached. With graduation so close, he can think of many ways to "invest" this $1,500. It so happens, however, that Andy's friend and employee Jason is an undergraduate finance major. Andy has no financial training, so he asks Jason if he can value the business and help sell Enviro-Lawn. Although anxious to sell, Andy wants to make sure that $15,000 is a fair price. After some thought (and the offer of 15% of any sales proceeds), Jason agrees to do his best to value the business and help sell it. After a brief review of his finance notes and text from last semester [Higgins, 1998], Jason creates the following to-do list to accomplish (along with studying for his final exams): Research other local lawn-care buyouts and get comparable offer multiples (for example, price to sales multiples). Use these multiples to calculate the market value of Enviro-Lawn. Value the company as a going concern using a discounted cash flow method. Research city population growth rates to extrapolate forecasted business growth rates. Construct pro forma statements using a percent of sales method with these growth predictions. Estimate the present value of the company from the future cash flows and terminal value. Perform a scenario analysis for the forecast using worst case, best case, and most likely case scenarios. Determine the company's liquidation value. Estimate the value of the customer list. Estimate the value of the equipment. Compare the different values arrived at using the three different approaches: market value based on multiples, market value based on discounted cash flows, and the current liquidation value. Use these values to determine and negotiate a fair price for Enviro-Lawn. Finding Comparable Multiples Jason decides his first step is to call several local lawn-care businesses to determine if he can discover relevant comparable buyout ratios for similar firms. He looks through the local phone book to identify other lawn businesses that may be prospective buyers. He recognizes a number of the competing firms and knows that many of them are small, one-or-two person businesses. He limits his call list to those that look most promising based upon his knowledge of the local industry. After approximately ten calls (seven of which are dead-ends), Jason determines the following information for three local businesses: LawnLife, a much larger company, has acquired smaller companies at prices ranging from 60% to 100% of annual revenues, depending on how well service prices matched up. After asking if LawnLife is in the acquisition market, however, Jason is told that LawnLife is not interested in purchasing any business at this time. Stewart's Pest Control and Lawn Service, another large yet local company, quotes similar multiples and (as a pleasant surprise to Jason) makes the following offer: Pay 100%, meaning 100% of 1st year's revenues, for all year-long contracts (most, about 80%, of Enviro-Lawn customers were on contract last year); Pay 60% for all one-time services (non-contracts); Help sell the contracts for Enviro-Lawn for the upcoming year; Disburse payments only as Stewart's collects from customers; Stewart's will not service the city of Heber (25% of last year's revenues came from Heber); and Because Stewart's charges more than Enviro-Lawn for service, customer's prices will be raised about 10% this year (increased prices will probably affect the return rate of customers). Blue-Diamond Pest Control, a company of similar size to Stewart's, offers to buy the remaining Heber City accounts (if Enviro-Lawn sells to Stewart's) or to assume all of the accounts under the following conditions: Pay 80% for all sold customers, including contracts and non-contracts; Help sell the contracts for Enviro-Lawn for the upcoming year; Disburse payments only as Blue-Diamond collects from customers; and Because Blue-Diamond's services and prices match Enviro-Lawn's, customer's prices will not be increased. Reflecting on his finance class, Jason realizes that the offer from Pete Williams can be considered selling the business as a "going concern." Williams' offer covers the entire business with the exception of debt. On the other hand, the offers from Stewart's and Blue-Diamond can be considered as liquidating the business. That is, Enviro-Lawn would cease to exist and the assets (contracts and equipment) would be sold at current market prices. Jason determines that each offer has its advantages and disadvantages. If sold to Pete Williams as a going concern, no additional work will be required. Andy and Jason are anxious to be done with the lawn and pest control business so they can prepare for graduation. But, the immediate liquidity of Pete's offer may not compensate for a premium above the $15,000 that may be earned with relatively little effort. An advantage of the Stewart's or Blue-Diamond offer is that either company is willing to help sell contracts at no additional cost. In addition, neither wants the equipment so it could be sold for salvage. If Andy and Jason (with the help of Stewart's and/or Blue-Diamond) sell enough contracts, liquidation may be more profitable than selling the business outright. Disadvantages of selling to Stewart's or Blue-Diamond include additional work for Andy and Jason and increased risk for all of the Enviro-Lawn owners. If sold to Stewart's or Blue-Diamond, Andy and Jason plan to sell the customer contracts themselves to increase the probability of successful sales. They would also have to find buyers for the equipment. Additionally, since they would receive no upfront payments, they would face some uncertainty about receiving the future payments. Of course they will take the best offer they can find, but Jason hopes that, by estimating the going concern and liquidation values, Enviro-Lawn will have a better idea of which offer comes closest to a fair value. Jason also feels that a price based on financial principles will increase Andy's ability for further negotiations. Using Discounted Cash Flows to Value the Firm Constructing the Pro Forma Statements Enviro-Lawn has managed its own finances using QuickBooks, and Jason has access to the past three years of income statements (see Figure 13-3). Because 1999 was the most typical year and is more representative of the future, Jason chooses to use 1999's revenues and expenses to construct pro forma income statements for the next four years. He has chosen to use a percent of sales method because most expenses are directly tied to revenues. Using this method, each year's revenues are forecasted to grow at an estimated rate. Then, variable expenses are calculated as a percentage of sales in the base year. Next, each variable expense percentage is multiplied by the forecasted sales number to determine the forecasted expense. For example, if sales are predicted to grow at 12%, then the 1999 sales are multiplied by 1.12 to determine the forecasted 2000 sales. Continuing, if an expense (say payroll, for example) is 25% of sales in 1999, then the new 2000 sales number is multiplied by 0.25 to determine the forecasted 2000 payroll expense. Variable expenses include everything except automobile purchases, telephone fees, office rent, professional fees, and storage rent. The following fixed expenses can capacitate any foreseen growth: telephone fees, office rent, professional fees, and storage rent. Existing equipment, on the other hand, can accommodate a 15% increase in revenues and then another truck and sprayer must be purchased. Jason figures he can account for these expenses under automobile purchases and equipment purchases on the pro forma income statement, both of which will remain zero until 15% growth from the base year of 1999 is forecasted. Jason estimates that a used truck can be purchased in the future for $5,000 and a sprayer for $3,000. Estimating Growth Rates As mentioned above, the first step of constructing the pro forma income statement is to estimate sales growth. Jason has determined from historical industry growth rates that sales growth is approximately the same as city growth rates. City growth rates affect the growth of the business because most new sales come from newly developed neighborhoods in high growth areas. Jason searches the Internet and finds projected growth rate data for the two counties (Wasatch and Utah Counties) that Enviro-Lawn primarily services (see Figure 13-4). These cities and percent of business within each city are: Orem (20%), Provo (20%), Heber (25%), and Spanish Fork (15%). The remaining 20% of the contracts is dispersed throughout Utah and Wasatch counties. Jason is confident that Enviro-Lawn can maintain the existing contracts in these cities. This year, Enviro-Lawn plans to target three additional cities that are in fast growth areas because the current cities serviced are fairly mature with relatively low growth rates. The first city, Woodland Hills, is in southern Utah County. Similar to their success in Heber, Andy and Jason feel they can expand the business in Woodland Hills because of its remote location. Many of the competing lawn services will not service these outlying areas. The second and third cities are located in southern Salt Lake CountyDraper and Riverton. The driving time to these cities is less than the drive to Heber, and Andy feels it will be worth the trip to service these fast growing areas. From Figure 13-4, Jason calculates the average annual growth rate to be approximately six percent for these three cities over the next three years. He decides to use six percent as his most likely case scenario growth rate. Using Discounted Cash Flows Jason remembers a helpful equation from his finance book [Higgins, 1998]: Present Value of Firm = Present Value (Free Cash Flows + Terminal Value) In other words, today's value of a business is equal to its ability to earn cash in the future. The number of years of cash flows attributed to a business depends on the individual business. Then, at the end of the forecasted period, terminal value is added to the last year's cash flow. Jason chooses to forecast four years of cash flows for the following reasons. Short run cash flows depend largely on the established firm; but long run cash flows may have little correlation to today, especially in a small business. Because Enviro-Lawn is a very small company, only the next four years' cash flows are considered, and then the terminal value of the firm, in four years, is added to the fourth year's cash flow. Enviro-Lawn's present value will simply be the present value of future cash flows for the next four years, including terminal value, discounted back to today at a given discount rate. The discount rate is the opportunity cost or rate of return that a purchaser could get for his money elsewhere at an equal risk. Because a fairly new and small lawn-care business is somewhat risky, Jason adds a risk premium of 20% to the risk free rate of return plus inflation, a combined 10%, giving a total discount rate of 30%. Estimating Terminal Values Jason recalls from his finance class that there are several different techniques to calculate the terminal value of a firm. For Enviro-Lawn, Jason feels the best approach is to use the liquidation value of assets. Based on this choice, the terminal value equals the value of the equipment plus the value of the customer list at the end of 2003. Jason takes the equipment's terminal value from the depreciation schedule which is a straight-line depreciation schedule based on the initial price and expected life of the equipment (see Figure 13-5). He uses book value as a conservative estimate, because he feels the book value will be somewhat less than market value. Given the current offers for the customer list and the costs associated with selling the list, Jason estimates that the customer list will be worth 50% of revenues in the terminal year. As mentioned above, these values, along with each year's cash flows, are discounted at 30% to obtain a present value of the business as a going concern. Performing Scenario Analysis for the Discounted Cash Flow Approach Jason wants to validate his valuation with scenario analysis. If he can show a strong value even under a worst-case scenario, he has leveraged Andy's position for negotiations. Additionally, a best-case scenario may prove useful if additional negotiations are needed. As mentioned above, Jason calculates six percent growth for the most likely scenario. Jason decides that a 50% decrease and a 50% increase would constitute the worst and best case scenarios, respectively. Thus, he uses three percent growth for his worst-case projections and nine percent for the best case. Determining the Company's Immediate Liquidation Value Liquidation will include selling the customer list and equipment consisting of two trucks, a 300-gallon sprayer, two aerators, and a power rake. The customer list is the most valuable asset. Andy assumes that customer loyalty and name recognition will make it easier to renew old customer contracts and gain new contracts. Last year, about 80% of all customers renewed contracts. Andy's concern is that the liquidation value will not be as high as selling the business as a going concern. His concern can be shown in a graph found in Figure 13-2 [Higgins, 1998]. Figure 13-2: Fair Value of Firm The graph indicates that in certain situations it is optimal to sell at liquidation value. and in other situations, it is best to sell as a going concern. Andy and Jason want to determine which value is higher and negotiate towards that value. Determining the Value of the Customer List The first part of liquidation is the customer list. Stewart's and Blue-Diamond have given favorable terms for buying the customer contracts, but Jason knows that depending on uncertain future cash flows is riskier than Pete Williams' up-front offer. If sales are low this year or if customers are unwilling to merge into a new company, the selling price could be minimal. Other disadvantages are that Jason and Andy have little time to sell contracts due to upcoming graduation, and they will have to pay two months of additional rent and phone costs totaling approximately $1,000. Jason has summarized the possible contract sales values as follows: Worst-case: $15,000 .80 = $12,000 Most-likely: $30,000 .80 = $24,000 Best-case: $45,000 .80 = $36,000 (The 80% figure comes from Blue-Diamond's offer. Jason chooses this offer because he feels it is the best package. However, if he has time to take a study break from his final exams, he is considering refining the multiple by using Stewart's offer as well. He has considered calculating a weighted average of Stewart's offer for all contracts other than Heber and Blue-Diamond's offer for Heber.) Determining the Value of the Equipment The value of the equipment with depreciation schedules is given in Figure 13-5. Andy is confident that he will be able to find buyers for the equipment at these book values. With this data, Jason uses the following relationship to determine liquidation value (excluding existing debt): Firm value (liquidation) = value of the contracts + the value of the equipment rent and phone costs Negotiating a Fair Price Jason and Andy will be meeting with the three companies separately, and they hope to sign an agreement. They will meet with Pete Williams; Rocky Martin from Stewart's; and Tommy Wilson from Blue-Diamond. Their goal is to present a fair price and negotiate an offer to meet or exceed the estimated firm value. They hope to do this by effectively organizing and communicating their own valuation of Enviro-Lawn to each prospective buyer. None of the potential buyers have financial backgrounds, and Andy is concerned about how information is presented to them. He has asked Jason to complete the valuation and present the material in a clear and summarized form before they meet with each company. Case Questions Using LawnLife's historical price-to-sales multiple, what is the value of Enviro-Lawn assuming a multiple of 0.6 (worst case), 0.8 (most-likely case), and 1.0 (best case)? Figure 13-3: Enviro-Lawn Annual Income Statements Figure 13-4: Utah Projected Population Growth Rates (Late 20th & Early 21stCenturies) How much is the business worth as a going concern using the discounted cash flow method? Create pro forma income statements and analyze cash flows for the next four years and the terminal value of the tangible assets and the customer list, at the end of year four. Create scenario analyses for the given growth rates under best, worst, and most-likely case scenarios. From Pete's standpoint, what price should he be willing to pay for a 30% return? Case Questions Figure 13-5: Calculate the liquidation value using the offer from Blue-Diamond. Considering the most-likely cases for both the liquidation and going concern values, how do the two values compare? Should Andy accept Pete's offer of $15,000? If so, why? If not, what would be a reasonable offer and why? For how much would Andy need to sell the business in order to get a 15% simple holding period return on the combined owners' initial investment? They have received no dividends, have received equitable salaries except where noted in the case, and currently have $10,000 of debt. The new owner will not assume the debt. Considering all of the offers, which would you choose and why? How do assumptions drive your results and recommendations? Comment on Jason's assumptions throughout the case.