How to value retained earnings?
March 18, 2020
by a searcher from Carleton College in Leesburg, VA, USA
I am looking at a small business in which the owners have kept a sizable amount of retained earnings in the business every year, growing the amount gradually after they've paid themselves relatively modest dividends. Now the retained earnings are approaching the size of their annual revenue. Is this normal? I think that it might be a good thing, especially as we look toward an economic slowdown, but does it affect the value of the business? Not surprisingly, they think the business is worth more than I would be prepared to offer based on an annual EBITDA multiple alone... Or are retained earnings from the previous year rolled into annual EBITDA?
from University of Pennsylvania in Indianapolis, IN, USA
For example, I led a transaction that had $2MM of EBITDA on $11MM of revenue, but there were $16MM of cash and marketable securities on the balance sheet. The deal was structured as an $8MM purchase price (rather than $24MM like they originally wanted) and the sellers kept the liquid assets less normal working capital. They saved an enormous amount in taxes structuring the deal that way.
In my opinion, unless you are buying an insurance carrier with surplus capital that must stay parked, it does not make sense to "purchase" retained earnings.
from Stanford University in Houston, TX, USA
So it's better to look at what assets they're tied to.:
-If it's cash/marketable securities, that's typically excluded from the transaction. If for some reason it is included, the cash value is added 1:1 on top of the business valuation; no multiple is assigned to cash.
-If it's fixed assets or NWC, that's a negotiating point. Most small businesses are priced as a multiple of FCF (or EBITDA or SDE), and not based on the balance sheet. So the price should technically come with whatever intangible, fixed, and NWC assets are needed for the business' day-to-day operations.....That said, if the Seller clearly has too much NWC or assets, and wants you to pay for it, you can ask to exclude some of it from the transaction and price.