Financial Engineering 101: Maximizing the Value of Your Company

One term that comes up often when we talk about private equity is “financial engineering.” Some people argue that private equity groups are too focused on financial engineering rather than organic growth. Others argue that it’s part of what they do best.

But what does it really mean? What would happen to your company if it were “financially engineered”?

In the days when investors only considered EBITDA as part of their purchases, fancy accounting techniques could be used to move recurring expenses to being one-time expenses or depreciation schedules could be manipulated to make the business have more free cash flow than would be expected. These practices earned financial engineering a bad reputation.s

However, most of these techniques aren’t effective any more. There is another side to financial engineering, the side that actually makes your business better. In order to make a business more profitable, there are really only two options. Grow your revenues while maintaining your margin or reduce costs while maintaining your revenues. That’s it.

Almost every bit of financial engineering a private equity group will do to make your company more profitable tends to circle around the second option – reducing costs while maintaining revenues. Here are 5 common ways they can make your business more valuable or more profitable:

Turning Owner Benefits into Free Cash Flow

Most business owners focus on pushing as many personal expenses into their business as possible because it is great for lowering your tax bill and maximizing your disposable income. With a creative accountant, you can push the envelope and save significant amounts of money.

But the tactic can hurt you in the long run, especially if you’re considering selling your business in the next few years. Private equity groups and other business buyers will value your business as a multiple of either the free cash flow or EBITDA of the business. Since buyers take on significant debt when buying a business, they only like to pay for the profits shown on tax returns each year. Writing off a significant portion of your income makes it extremely difficult to prove the money is actually profit, even if you’re using it as “owner discretionary spending”.

Some buyers can use the discretionary spending as a means for lower valuations. If you are considering a sale in the next 3-5 years, it can be very effective to focus on the company’s EBITDA, rather than your personal tax benefits,  to maximize your company’s valuation. Without doing anything materially to your company, the value will increase.

Optimize the Cash Flow Cycle

Often, when your business has been growing consistently over time, you don’t worry too much about how cash is flowing through your business. As long as money comes in faster than it goes out, you just keep doing what you’ve always done. But that can mean leaving a significant amount of profit on the table and can leave your business at risk in less stable times.

Paying closer attention to these cycles can do a lot to improve the efficiency and value of your business — especially since your business can only grow as fast as you can turn orders into cash. If it takes your business two weeks to bill a client after a sale, that’s time you still have to pay employees and suppliers, but don’t have cash in the accounts yet. You’ll either have to pay that money out of previous profits or will have to pay interest on working capital loans, neither of which is a preferable outcome.

Minor changes to your cash collection strategies can have significant impacts on your working capital issues. For example, if you work with suppliers and negotiate payment terms longer than net-30, but your own receivables are on a net-15 pay scale, you could potentially end up with negative working capital. Over time this strategy could yield a cash buffer in case there are issues in your company. Ensuring you always pay your bills on time to reduce late payment penalties can also increase the profitability of the company.

Private equity groups are managed by people with finance backgrounds who will try to fix your cash flows immediately. Why wait for them to take over to make your financial processes solid? If you can master the cash flow cycle, your working capital will be much smoother and your business more predictable leading to less stress and a more valuable company.

Sale/Leasebacks and other asset backed loans

If you have a business that is scaling and growing predictably, one of the hardest challenges can be accessing more working capital to expand your business. Often your first instinct will be to look for external equity investors, but private equity groups usually start by looking inside your company.

One of the biggest drains on capital available to grow your business can be large assets. If you run a plastic injection molding company, it’s likely you own a warehouse and a manufacturing facility. Each machine in the facility can be worth $250k+ and is depreciating as you use it.

Private equity groups will often access growth capital by obtaining asset backed loans or by doing a sale/leaseback. In a sale/leaseback you sell your equipment to another investor who leases it back to you on a long-term contract. The arrangement gives the new investor access to a predictable income stream and can give your company access to the capital you need to expand. It can allow you to hire more employees, spend more on marketing and sales, or lease another facility and machinery as needed.

Don’t wait for the private equity group to use this strategy with your business, access the asset backed capital yourself to grow your company.

Multiple Arbitrage

As your company grows, the value of the business grows faster than your earnings because larger businesses are generally seen as more stable and more predictable. In some cases, incremental earnings can have a significant impact on your sales price.

For example, a business services company with around $500k in earnings will often be valued at 1-2x earnings. There is a fair amount of risk in the business and it’s still being directly managed by the owner in most cases. A company with $5M in earnings, on the other hand, will be valued more in the 5-8x range because it’s a larger, more professional company with significantly less risk and a higher likelihood of scalable growth.

One way to use the value difference to your advantage is to acquire the revenues and earnings of smaller companies in order to grow your overall value. If the $5M earnings company acquired the $500k earnings company, the larger company would likely pay around $1M for the business. But, immediately after adding the $500k to their balance sheet, the new earnings would be worth $2.5 – 4M dollars. The $500k would be valued at a 5-8x multiple rather than the 1-2x multiple. And thus, multiple arbitrage.

Making acquisitions for the sake of acquisitions can be extremely dangerous. You have to be careful to make strategic acquisitions that can actually benefit your business beyond simple arbitrage. Still, the concept can open up a wider range of acquisitions than you would likely otherwise consider on their own.

Lowering Taxes Through Interest Payments

Private equity groups never write off personal expenses through a business, but they do use a different trick to reduce their tax bill. Instead, they take advantage of how loan interest is treated for tax purposes.

In the US, interest payments on business loans are considered before profits rather than after profits for tax reasons. So, if your company made $1M this year in profits but had to pay $800k in interest payments on loans you had outstanding, you would only owe taxes on $200k. The federal tax rate for companies is 15%, meaning you’d pay $30k in taxes rather than $150k in taxes on the company’s profits.

Private equity groups use this to their advantage in a few ways. The most common way is to buy a very large company with a loan – otherwise known as a leveraged buyout. Since the company pays for the loan interest, a large loan is mostly paid by company profits. As long as the company is stable, it’s a very effective strategy for making acquisitions. And, by focusing on growing enterprise value, a sale later results in paying off the loan and taking the difference in purchase and sale price as their profits.

While leveraging your own business is easily the most aggressive strategy for an individual business owner, be aware that variations of avoiding taxes through interest rates will be used by private equity groups if they buy your business. The strategy makes your business more fragile, but can be profitable if you pull it off. We definitely recommend consulting with your financial advisor before employing this, or any of the above tactics.

What are some of your favorite ways to ‘financially engineer’ a company?