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Stand alone versus open market

Most owners don’t know very much about the various methods of valuing companies, which is completely understandable because the methods are a profession in itself.

April 7, 2017  By Victor Harding

There are several common methods used to value companies. A thorough valuation should look at more than one method to get a truly accurate picture. I would list the common methods as follows:

Asset valuation
This is used mainly when a business is being wound up. It is very seldom used with going concerns.

Market comparison
This is always useful as a secondary method but never great as the primary method of valuation because it is hard to find two companies the same.

Discounted cash flow
This is the most common method used for larger companies but it has its issues. It is complicated to do. It is not clear what discount rate to use. For example, what about that large residual value attached to the company from the cash flow more than five years out?

Multiple of Recurring Monthly Revenue (RMR)
This method is used mainly for what I call recurring revenue where the major source of value is the RMR. A multiple of RMR is just a shortened form of discounted cash flow.

Multiple of average “normalized” earnings or EBITDA
This is the most common method for valuing most small and medium-sized companies where RMR is not the major source of value. I use this method almost always to value integration, fire and guard companies. Calculating average normalized earnings, deciding what multiple to use of earnings and whether to use earnings or EBITDA is an article in itself.

If you are looking for a proper valuation on your company and are not sure which method to use, it is best to hire someone who knows the security industry to do it for you.

But there is an even more basic, over-riding concept in business valuation theory that often is overlooked even by business valuators. This is the concept of “Stand Alone” versus “Open Market” Values for your business. They can be dramatically different. Here I am drawing on what I have learned from Ian Campbell in his book  “50 Hurdles.” Ian is a foremost authority in Canada on valuing companies.

A good example to illustrate the difference between a Stand Alone versus Open Market valuation of your business would be where one partner wants or has to buy the other one out and there is no explicit shareholder agreement laying out how the valuation should be done.

A Stand Alone value is the result of a valuation process where the business will operate pretty much the same before a partner has been bought out as after. The business has same asset base, same overhead and cost structure and usually the same management both before and after the shareholder buy-out. In the Stand Alone situation, the business is specifically not offered for sale on the open market.

An Open Market valuation results from the situation where the business is offered for sale on the open market and a “strategic” (as opposed to financial) buyer values the company based on their conviction that they can get cost reductions or synergies out of the business after. Accordingly, there is often incremental value attached to the business because of the potential synergies. As a result, Open Market valuations are most often higher than Stand Alone values.

How does all of this apply to us in the security industry? If you are a partner in your business and don’t have a very explicit shareholder’s agreement that lays out exactly how the company is to be valued and one partner wants to buy out another, then it is likely that you should be valuing your company on a Stand Alone basis. Everything is going to stay much the same with the business after the buyout. There are no great synergies to be realized. Accordingly, the valuation you end up with should likely be lower than if you placed your company on the open market.

This makes sense it you look at, for example, a medium-sized alarm company with 5,000 accounts. An Open Market valuation of this company from a strategic buyer, like ADT, will likely reflect some of the cost reductions or synergies that ADT can get when buying this account base. ADT will likely not need all the company’s clerical or customer service staff nor will it likely cost the same amount to monitor the 5,000 accounts in the ADT station. This is why the larger consolidators like ADT can and do pay multiples that on the surface seem high — like 36-38 X RMR for 5,000 accounts. They will get synergies after the transaction is done.

It is worth noting that we have become so accustomed to tossing around these higher multiples for alarm companies (i.e. 34-40 X) that we sometimes forget that these multiples reflect Open Market values where synergies can be had.
On the other hand, one partner buying out another with that same 5,000 account company will not likely want to pay 36-38 X because the business is not going to realize any real synergies.

How much of a difference there will be between a stand-alone and open market valuation is hard to say. You won’t know for sure unless you put the business up for sale, but in my experience it is likely to be large enough to push the partners to put the company on the open market rather than just sell to each other.

Victor Harding is the principal of Harding Security Services  (victor@hardingsecurity.ca).

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