Pe Interview

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private equity is an asset class consisting of

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equity securities in operating companies that are not publicly traded on a stock exchange

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Among the most common investment strategies in private equity include

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leveraged buyouts, venture capital, growth capital, distressed investments and mezzanine capital.

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Growth capital (also "expansion capital" and "growth equity") is a type of private equity investment, most often

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a minority investment, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a significant acquisition without a change of control of the business

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Companies that seek growth capital, will often do so in order to finance

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a transformational event in their lifecycle. These companies are likely to be more mature than venture capital funded companies, able to generate revenue and operating profits but unable to generate sufficient cash to fund major expansions, acquisitions or other investments. Growth capital can also be used to effect a restructuring of a company's balance sheet, particularly to reduce the amount of leverage (or debt) the company has on its balance sheet.

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A private investment in public equity, often called a PIPE deal, involves the

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selling of publicly traded common shares or some form of preferred stock or convertible security to private investors. In the U.S. a PIPE offering may be registered with the Securities and Exchange Commission on a Registration Statement or may be completed as an unregistered private placement.

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For private equity investors, PIPEs tend to become increasingly attractive in markets where control investments

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are harder to execute. Generally, companies are forced to pursue PIPEs when capital markets are unwilling to provide financing and traditional equity market alternatives do not exist for that particular issuer.

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The immediate cause or trigger of the crisis was the

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bursting of the United States housing bubble which peaked in approximately 2005–2006.[6][7] High default rates on "subprime" and adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher.


Share in GDP of U.S. financial sector since 1860.[8]In the years leading up to the start of the crisis in 2007, significant amounts of foreign money flowed into the U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds made it easier for the Federal Reserve to keep interest rates in the United States too low (by the Taylor rule) from 2002–2006 which contributed to easy credit conditions, leading to the United States housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.[9][10] As part of the housing and credit booms, the amount of financial agreements called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Falling prices also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues to drain wealth from consumers and erodes the financial strength of banking institutions. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.[11]

While the housing and credit bubbles built, a series of factors caused the financial system to both expand and become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations.[12] These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses.[13] These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to provide funds to encourage lending and restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions and implemented economic stimulus programs, assuming significant additional financial commitments.

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The history of private equity and venture capital and the development of these asset classes has occurred through a series of boom and bust cycles since the middle of the 20th century. Within the broader private equity industry, two distinct sub-industries, leveraged buyouts and venture capital experienced growth along parallel, although interrelated tracks.

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Since the origins of the modern private equity industry in 1946, there have been four major epochs marked by three boom and bust cycles. The early history of private equity—from 1946 through 1981—was characterized by relatively small volumes of private equity investment, rudimentary firm organizations and limited awareness of and familiarity with the private equity industry. The first boom and bust cycle, from 1982 through 1993, was characterized by the dramatic surge in leveraged buyout activity financed by junk bonds and culminating in the massive buyout of RJR Nabisco before the near collapse of the leveraged buyout industry in the late 1980s and early 1990s. The second boom and bust cycle (from 1992 through 2002) emerged out of the ashes of the savings and loan crisis, the insider trading scandals, the real estate market collapse and the recession of the early 1990s. This period saw the emergence of more institutionalized private equity firms, ultimately culminating in the massive Dot-com bubble in 1999 and 2000. The third boom and bust cycle (from 2003 through 2007) came in the wake of the collapse of the Dot-com bubble—leveraged buyouts reach unparalleled size and the institutionalization of private equity firms is exemplified by the Blackstone Group's 2007 initial public offering.

In its early years through roughly the year 2000, the history of the private equity and venture capital asset classes is best described through a narrative of developments in the United States as private equity in Europe consistently lagged behind the North American industry. With the second private equity boom in the mid-1990s and liberalization of regulation for institutional investors in Europe, the emergence of a mature European private equity market has occurred.

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What Does Leveraged Buyout - LBO Mean?

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The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.

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Investopedia explains Leveraged Buyout - LBO

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In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds usually are not investment grade and are referred to as junk bonds. Leveraged buyouts have had a notorious history, especially in the 1980s when several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company's operating cash flows were unable to meet the obligation.

As of 2006, the largest LBO to date was the acquisition of HCA Inc. in 2006 by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch. According to the Washington Post, the three companies paid around $33 billion for the acquisition.

It can be considered ironic that a company's success (in the form of assets on the balance sheet) can be used against it as collateral by a hostile company that acquires it. For this reason, some regard LBOs as an especially ruthless, predatory tactic.

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LBO modeling steps

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1.Basic sources and uses – don’t try to get fancy here with equity rollovers, PIK, 10 tranches of debt or anything. Go with a simple view that has the purchase price and debt/equity used. Maybe do 1-2 tranches of debt but keep things simple. You need to get across that you understand the basic concepts behind an LBO model, not the super-advanced stuff.
2.Basic income statement – just do basic projections here, with revenue growth, SG&A or whatever expenses you have as a % of revenue and go down to EBITDA. You can make a few basic assumptions to get to net income as well for the cash flow statement, but again don’t go overboard.
3.Basic balance sheet – Have the basics, like Cash, Accounts Receivable, Accounts Payable, PP&E and Debt, and use easy assumptions for these. You should include acquisition effects like the new debt and any cash used as well as goodwill, but I would keep this as simple as you can while still making it, um, balance.
4.Basic cash flow statement – Net income, add back D&A and the change in working capital and subtract CapEx to get to your cash flow available for debt repayment.
5.Basic debt structure – just do the bare minimum in terms of Excel functions here and assume you can use all Free Cash Flow for interest/principal repayment each year. Should just be a couple MIN functions.
6.IRR calculation at the end and maybe a few sensitivity tables on purchase price, exit multiples, and growth rates/margins.

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PE introduction/basic points presentation slides

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Summary Slide

Do the following in 3-4 major bullets:

•Do we invest in this company? Yes or no – no “maybes” or “conditional upon” statements – they want a decision one way or the other.
•Support your decision with major points: Give 1-2 bullets to support your decision, focusing on the major items – not tiny details that don’t matter.
•Hedge your decision by pointing out the key investment risk: No investment is perfect, and everything has risks associated with it – point out the major 1 or 2 risks that are apparent with your company right here.

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PE qualitative presentation qualitative slides

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Qualitative Slides

These slides are highly dependent on the company you’re analyzing – at a minimum, though, you need to think about the following:

•Market: Is this an industry that’s growing? Will it grow more quickly/slowly in future years? Do you see positive or negative trends due to technology / regulations / competitors? Where does this company stand next to the competition?
•Competition: How does this company fare against its competitors? Does it have some type of unique advantage that others can’t replicate? What about the barriers to entry?
•Growth Opportunities: How quickly can the company grow in the future? Is there any “low hanging fruit” or room to easily win more customers / revenue in the future? Do you expect it to grow faster or slower than the market as a whole?
•Risks: Every investment carries with it risks – are the key risks here related to the market, or the economy as a whole? To the competition? To government regulations? And is there any way of mitigating these risks?
•Other: If there’s anything especially notable about the management team, the products/services or other items unique to the deal, you can mention them as well – but stay away from saying, “The CEO is great!” because you have no way of knowing that.

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PE quantitative slides

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1.Spending hours and hours searching for EBITDA add-backs and adjustments for each company in their filings.
2.Spending hours debating which pub comps and transaction comps you should be using.
3.Creating a detailed LBO model that handles 500 different cases and also adjusts perfectly for items that no one cares about.

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What Does Private Equity Mean?

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Equity capital that is not quoted on a public exchange. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet.

The majority of private equity consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public company.

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Investopedia explains Private Equity

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The size of the private equity market has grown steadily since the 1970s. Private equity firms will sometimes pool funds together to take very large public companies private. Many private equity firms conduct what are known as leveraged buyouts (LBOs), where large amounts of debt are issued to fund a large purchase. Private equity firms will then try to improve the financial results and prospects of the company in the hope of reselling the company to another firm or cashing out via an IPO.

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Risk capital investors are prepared to invest at high levels of risk. But they will look at your investment proposal to see if it provides these assurances:

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•a potential for high, sustainable, profitable growth;

•a comprehensive plan that demonstrates that your project has the potential to exploit a market opportunity;

•a qualified and balanced management team with the ability to implement well-defined strategic objectives and plans, supported by key individuals associated with your business (founders/owners, board of directors, current investors, accountants, lawyers, consultants);

•a potential rate of return on the investment that is proportional to the level of assumed risk;

•ways for investors to monitor, influence and control their investment; and

•a viable exit strategy for investors that offers a suitable return on their investment.

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growth-oriented enterprises —

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that have new business models, leadership position in new or emerging markets, or some type of new technology. And, if they are skilfully managed, they may be able to create exceptional wealth for owners or shareholders

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Financial modeling is the task of building an

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abstract representation (a model) of a financial decision making situation. This is a mathematical model, such as a computer simulation, designed to represent (a simplified version of) the performance of a financial asset or a portfolio, of a business, a project, or any other form of financial investment.

Financial modeling is a general term that means different things to different users. In the US and particularly in business schools it means the development of a mathematical model, often using complex algorithms, and the associated computer implementation to simulate scenarios of financial events, such as asset prices, market movements, portfolio returns and the like. Or it might mean the development of optimization models for managing and controlling the risk of a financial investment. In Europe and in the accounting profession financial modelling is defined as cash flow forecasting, involving the preparation of large, detailed spreadsheets for management decision making purposes.

While there has been some debate in the industry as to the nature of financial modeling : whether it is a tradecraft, such as welding, or a science, such as metallurgy, the task of financial modeling has been gaining acceptance and rigor over the years. Several scholarly books have been written on the topic, in addition to numerous scientific articles, and the definitive series Handbooks in Finance by Elsevier contains several volumes dealing with financial modeling issues.

There are non-spreadsheet software platforms available on which to build financial models. However, the vast proportion of the market is spreadsheet-based, and within this market Microsoft Excel now has by far the dominant position, having overtaken Lotus 1-2-3 in the 1990s. From this it is easy to see how the uninformed can equate Financial modeling competency with 'learning Excel'. However, the fallacy in this contention is the one area on which professionals and experts in the financial modeling industry agree.

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The First Chicago Method or Venture Capital Method is a context specific approach used by venture capital and private equity investors that combines elements of both a

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multiples-based valuation and a discounted cash flow (DCF) valuation approach.[1]

Rather than completing a valuation of the company, the First Chicago Method takes account of payouts to the holder of specific investments in a company through the holding period under various scenarios. Most often this methodology will involve the construction of:

An "upside case" or "best case scenario"
A "base case"
A "downside" or "worst case scenario"
The method is used particularly in the valuation of growth companies which often do not have historical financial results that can be used for meaningful comparable company analysis. Multiplying actual financial results against a comparable valuation multiple often yields a value for the company that is objectively too low given the prospects for the business.

Often the First Chicago Method may be preferable to a Discounted Cash Flow taken alone. This is because such income-based business value assessment may lack the support generally observable in the market place. Indeed, professionally performed business appraisals go further and use a set of methods under all three approaches to business valuation.[2]

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Normalization of financial statements for financial valuation

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The most common normalization adjustments fall into the following four categories:

Comparability Adjustments. The valuer may adjust the subject company’s financial statements to facilitate a comparison between the subject company and other businesses in the same industry or geographic location. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company’s data is presented in its financial statements.
Non-operating Adjustments. It is reasonable to assume that if a business were sold in a hypothetical sales transaction (which is the underlying premise of the fair market value standard), the seller would retain any assets which were not related to the production of earnings or price those non-operating assets separately. For this reason, non-operating assets (such as excess cash) are usually eliminated from the balance sheet.
Non-recurring Adjustments. The subject company’s financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statements will better reflect the management’s expectations of future performance.
Discretionary Adjustments. The owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair market value, the owner’s compensation, benefits, perquisites and distributions must be adjusted to industry standards. Similarly, the rent paid by the subject business for the use of property owned by the company’s owners individually may be scrutinized.

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Income, Asset and Market Approaches

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Three different approaches are commonly used in business valuation: the income approach, the asset-based approach, and the market approach[2]. Within each of these approaches, there are various techniques for determining the value of a business using the definition of value appropriate for the appraisal assignment. Generally, the income approaches determine value by calculating the net present value of the benefit stream generated by the business (discounted cash flow); the asset-based approaches determine value by adding the sum of the parts of the business (net asset value); and the market approaches determine value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region.

A number of business valuation models can be constructed that utilize various methods under the three business valuation approaches. Venture Capitalists and Private Equity professionals have long used the First chicago method which essentially combines the income approach with the market approach.

In determining which of these approaches to use, the valuation professional must exercise discretion. Each technique has advantages and drawbacks, which must be considered when applying those techniques to a particular subject company. Most treatises and court decisions encourage the valuator to consider more than one technique, which must be reconciled with each other to arrive at a value conclusion. A measure of common sense and a good grasp of mathematics is helpful.

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The income approaches determine fair market value by

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multiplying the benefit stream generated by the subject or target company times a discount or capitalization rate. The discount or capitalization rate converts the stream of benefits into present value. There are several different income approaches, including capitalization of earnings or cash flows, discounted future cash flows (“DCF”), and the excess earnings method (which is a hybrid of asset and income approaches). Most of the income approaches look to the company’s adjusted historical financial data for a single period; only DCF requires data for multiple future periods. The discount or capitalization rate must be matched to the type of benefit stream to which it is applied. The result of a value calculation under the income approach is generally the fair market value of a controlling, marketable interest in the subject company, since the entire benefit stream of the subject company is most often valued, and the capitalization and discount rates are derived from statistics concerning public companies.

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The Capital Asset Pricing Model ( CAPM) is one method of determining

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the appropriate discount rate in business valuations. The CAPM method originated from the Nobel Prize winning studies of Harry Markowitz, James Tobin and William Sharpe. The CAPM method derives the discount rate by adding a risk premium to the risk-free rate. In this instance, however, the risk premium is derived by multiplying the equity risk premium times “beta,” which is a measure of stock price volatility. Beta is published by various sources for particular industries and companies. Beta is associated with the systematic risks of an investment.

One of the criticisms of the CAPM method is that beta is derived from the volatility of prices of publicly-traded companies, which are likely to differ from private companies in their capital structures, diversification of products and markets, access to credit markets, size, management depth, and many other respects. Where private companies can be shown to be sufficiently similar to public companies, however, the CAPM method may be appropriate.

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The weighted average cost of capital is an approach to determining

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a discount rate. The WACC method determines the subject company’s actual cost of capital by calculating the weighted average of the company’s cost of debt and cost of equity. The WACC must be applied to the subject company’s net cash flow to total invested capital.

One of the problems with this method is that the valuator may elect to calculate WACC according to the subject company’s existing capital structure, the average industry capital structure, or the optimal capital structure. Such discretion detracts from the objectivity of this approach, in the minds of some critics.

Indeed, since the WACC captures the risk of the subject business itself, the existing or contemplated capital structures, rather than industry averages, are the appropriate choices for business valuation.

Once the capitalization rate or discount rate is determined, it must be applied to an appropriate economic income streams: pretax cash flow, aftertax cash flow, pretax net income, after tax net income, excess earnings, projected cash flow, etc. The result of this formula is the indicated value before discounts. Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches.

Careful matching of the discount rate to the appropriate measure of economic income is critical to the accuracy of the business valuation results. Net cash flow is a frequent choice in professionally conducted business appraisals. The rationale behind this choice is that this earnings basis corresponds to the equity discount rate derived from the Build-Up or CAPM models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows. At the same time, the discount rates are generally also derived from the public capital markets data.

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The Build-Up Method is a

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widely-recognized method of determining the after-tax net cash flow discount rate, which in turn yields the capitalization rate. The figures used in the Build-Up Method are derived from various sources. This method is called a “build-up” method because it is the sum of risks associated with various classes of assets. It is based on the principle that investors would require a greater return on classes of assets that are more risky. The first element of a Build-Up capitalization rate is the risk-free rate, which is the rate of return for long-term government bonds. Investors who buy large-cap equity stocks, which are inherently more risky than long-term government bonds, require a greater return, so the next element of the Build-Up method is the equity risk premium. In determining a company’s value, the long-horizon equity risk premium is used because the Company’s life is assumed to be infinite. The sum of the risk-free rate and the equity risk premium yields the long-term average market rate of return on large public company stocks.

Similarly, investors who invest in small cap stocks, which are riskier than blue-chip stocks, require a greater return, called the “size premium.” Size premium data is generally available from two sources: Morningstars' (formerly Ibbotson & Associates') Stocks, Bonds, Bills & Inflation and Duff & Phelps' Risk Premium Report.

By adding the first three elements of a Build-Up discount rate, we can determine the rate of return that investors would require on their investments in small public company stocks. These three elements of the Build-Up discount rate are known collectively as the “systematic risks.”

In addition to systematic risks, the discount rate must include “unsystematic risks,” which fall into two categories. One of those categories is the “industry risk premium.” Morningstar’s yearbooks contain empirical data to quantify the risks associated with various industries, grouped by SIC industry code.

The other category of unsystematic risk is referred to as “specific company risk.” Historically, no published data has been available to quantify specific company risks. However as of late 2006, new ground-breaking research has been able to quantify, or isolate, this risk for publicly-traded stocks through the use of Total Beta calculations. P. Butler and K. Pinkerton have outlined a procedure, known as the Butler Pinkerton Model (BPM), using a modified Capital Asset Pricing Model ( CAPM) to calculate the company specific risk premium. The model uses an equality between the standard CAPM which relies on the total beta on one side of the equation; and the firm's beta, size premium and company specific risk premium on the other. The equality is then solved for the company specific risk premium as the only unknown. The BPM is a relatively new concept and is gaining acceptance in the business valuation community.

It is important to understand why this capitalization rate for small, privately-held companies is significantly higher than the return that an investor might expect to receive from other common types of investments, such as money market accounts, mutual funds, or even real estate. Those investments involve substantially lower levels of risk than an investment in a closely-held company. Depository accounts are insured by the federal government (up to certain limits); mutual funds are composed of publicly-traded stocks, for which risk can be substantially minimized through portfolio diversification.

Closely-held companies, on the other hand, frequently fail for a variety of reasons too numerous to name. Examples of the risk can be witnessed in the storefronts on every Main Street in America. There are no federal guarantees. The risk of investing in a private company cannot be reduced through diversification, and most businesses do not own the type of hard assets that can ensure capital appreciation over time. This is why investors demand a much higher return on their investment in closely-held businesses; such investments are inherently much more risky.

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The value of asset-based analysis of a business is equal to the

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sum of its parts. That is the theory underlying the asset-based approaches to business valuation. The asset approach to business valuation is based on the principle of substitution: no rational investor will pay more for the business assets than the cost of procuring assets of similar economic utility. In contrast to the income-based approaches, which require the valuation professional to make subjective judgments about capitalization or discount rates, the adjusted net book value method is relatively objective. Pursuant to accounting convention, most assets are reported on the books of the subject company at their acquisition value, net of depreciation where applicable. These values must be adjusted to fair market value wherever possible. The value of a company’s intangible assets, such as goodwill, is generally impossible to determine apart from the company’s overall enterprise value. For this reason, the asset-based approach is not the most probative method of determining the value of going business concerns. In these cases, the asset-based approach yields a result that is probably lesser than the fair market value of the business. In considering an asset-based approach, the valuation professional must consider whether the shareholder whose interest is being valued would have any authority to access the value of the assets directly. Shareholders own shares in a corporation, but not its assets, which are owned by the corporation. A controlling shareholder may have the authority to direct the corporation to sell all or part of the assets it owns and to distribute the proceeds to the shareholder(s). The non-controlling shareholder, however, lacks this authority and cannot access the value of the assets. As a result, the value of a corporation's assets is rarely the most relevant indicator of value to a shareholder who cannot avail himself of that value. Adjusted net book value may be the most relevant standard of value where liquidation is imminent or ongoing; where a company earnings or cash flow are nominal, negative or worth less than its assets; or where net book value is standard in the industry in which the company operates. None of these situations applies to the Company which is the subject of this valuation report. However, the adjusted net book value may be used as a “sanity check” when compared to other methods of valuation, such as the income and market approaches.

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The market approach to business valuation is rooted in the economic principle of competition:

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that in a free market the supply and demand forces will drive the price of business assets to a certain equilibrium. Buyers would not pay more for the business, and the sellers will not accept less, than the price of a comparable business enterprise. It is similar in many respects to the “comparable sales” method that is commonly used in real estate appraisal. The market price of the stocks of publicly traded companies engaged in the same or a similar line of business, whose shares are actively traded in a free and open market, can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit meaningful comparison.

The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for this purpose. Also, as for a private company, the equity is less liquid (in other words its stocks are less easy to buy or sell) than for a public company, its value is considered to be slightly lower than such a market-based valuation would give.

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Common Errors in Financial Modeling:

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1.Conversion factors (kilobytes to megabytes, monthly to annual, millions to thousands, etc).
2.Range included in totals (certain rows not included).
3.Calculation formula not replicated across columns.
4.Wrong row references in calculation formula.
5.Wrong column references in starting time period (each column should typically contain references only from that column).
6.Change in cell references in formulae referring to other workbooks.
7.Algebraic errors (wrong use of brackets, plus/minus errors).
8.Range limits not set (eg, having negative number of customers or negative distributor commission payments).
9.Hard coded dummy numbers / assumptions perpetuating in the financial model due to oversight.

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3 Golden rules for Financial Analysts to Avoid Errors in

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Financial Models:

1.Be diligent when building the financial model, a little concentration and attention to detail early on will save you a lot of time and work later.
2.Ask another person not in the financial modeling team to conduct a detailed audit, very often a fresh pair of eyes may spot errors then are’nt obvious to someone who’s been looking at the same spreadsheet for days or weeks on end.
3.Perform sanity checks on outputs through benchmarking exercises, always use your common sense and business knowledge to ensure that the results of your financial model (e.g. individual product revenues or cost items, etc) are realistic and aligned with what you may expect them to be.

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The terminal value is the

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value of the company’s expected cash flow beyond the explicit forecast horizon. A high-quality estimate of terminal value is critical because it often accounts for a large percentage of the total value of the company in a discounted cash flow valuation.

As a result, all financial analysts should be familiar with the mechanics of terminal value and how it is calculated in order to ensure an accurate financial modeling and valuation exercise.

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Free cash flow (FCF) is equal to the

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after-tax operating earnings of the company plus non-cash charges less investments in working capital, plant, property and equipment (or PP&E), and other assets.

FCF is the cash flow generated by a company that is available to all providers of capital, both debt and equity.

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What is business valuation?

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Quite simply, business valuation is a process and a set of procedures used to determine what a business is worth. While this sounds easy enough, getting your business valuation done right takes preparation and thought.

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Business valuation results depend on your assumptions

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For one thing, there is no one way to establish what a business is worth. That's because business value means different things to different people.

A business owner may believe that the business connection to the community it serves is worth a lot. An investor may think that the business value is entirely defined by its historic income.

In addition, economic conditions affect what people believe a business is worth. For instance, when jobs are scarce, more business buyers enter the market and increased competition results in higher business selling prices.

The circumstances of a business sale also affect the business value. There is a big difference between a business that is shown as part of a well-planned marketing effort to attract many interested buyers and a quick sale of business assets at an auction.

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Expected selling price and business value

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Hence, business value is really an expected price the business would sell for. The real price may vary quite a bit depending on who determines the business value. Compare a buyer who wants the business now because it fits important lifestyle goals to a buyer that purchases an income stream at the lowest price possible.

The selling price also depends on how the business sale is handled. Contrast a well-conducted business marketing campaign and a "fire sale".

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That said, there are three fundamental ways to measure what a business is worth:

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Asset Approach
Market Approach
Income Approach

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Asset approach

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The asset approach views the business as a set of assets and liabilities that are used as building blocks to construct the picture of business value. The asset approach is based on the so-called economic principle of substitution which addresses this question:

What will it cost to create another business like this one that will produce the same economic benefits for its owners?

Since every operating business has assets and liabilities, a natural way to address this question is to determine the value of these assets and liabilities. The difference is the business value.

Sounds simple enough, but the challenge is in the details: figuring out what assets and liabilities to include in the valuation, choosing a standard of measuring their value, and then actually determining what each asset and liability is worth.

For example, many business balance sheets may not include the most important business assets such as internally developed products and proprietary ways of doing business. If the business owner did not pay for them, they don't get recorded on the "cost-basis" balance sheet!

But the real value of such assets may be far greater than all the "recorded" assets combined. Imagine a business without its special products or services that make it unique and bring customers in the door!

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Market approach

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The market approach, as the name implies, relies on signs from the real market place to determine what a business is worth. Here, the so-called economic principle of competition applies:

What are other businesses worth that are similar to my business?

No business operates in a vacuum. If what you do is really great then chances are there are others doing the same or similar things. If you are looking to buy a business, you decide what type of business you are interested in and then look around to see what the "going rate" is for businesses of this type.

If you are planning to sell your business, you will check the market to see what similar businesses sell for.

It is intuitive to think that the "market" will settle to some idea of business price equilibrium - something that the buyers will be willing to pay and the sellers willing to accept. That's what is known as the fair market value:

The business price that a willing buyer will pay, and a willing seller will accept for the business. Both parties are assumed to act in full knowledge of all the relevant facts, and neither being under compulsion to conclude the sale.

So the market approach to valuing a business is a great way to determine its fair market value - a monetary value likely to be exchanged in an arms-length transaction, when the buyer and seller act in their best interest. Market data is great if you need to support your offer or asking price - after all, if the "going rate" is this much, why would you offer more or accept less?

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Income approach

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The income approach takes a look at the core reason for running a business - making money. Here the so-called economic principle of expectation applies:

If I invest time, money and effort into business ownership, what economic benefits and when will it provide me?

Notice the future expectation of economic benefit in the above sentence. Since the money is not in the bank yet, there is some measure of risk - of not receiving all or part of it when you expect it. So, in addition to figuring out what kind of money the business is likely to bring, the income valuation approach also factors in the risk.

Since the business value must be established in the present, the expected income and risk must be translated to today. The income approach uses two ways to do this translation:

Capitalization
Discounting

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Business valuation by direct capitalization

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In its simplest form, the capitalization method basically divides the business expected earnings by the so-called capitalization rate. The idea is that the business value is defined by the business earnings and the capitalization rate is used to relate the two.

For example, if the capitalization rate is 33%, then the business is worth about 3 times its annual earnings. An alternative is a capitalization factor that is used to multiply the income. Either way, the result is what the business value is today.

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Valuation of a business by discounting its cash flows

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The discounting method works a bit differently: first, you project the business income stream over some future period of time, usually measured in years. Next, you determine the discount rate which reflects the risk of getting this income on time.

Last, you figure out what the business will be worth at the end of the projection period. This is called the residual or terminal business value. Finally, the discounting calculation gives you the so-called present value of the business, or what it is worth today.

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Business valuation and risk: discount and cap rates are related

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Since both income valuation methods do the same thing, you would expect similar results. If fact, the capitalization and discount rates are related:

CR = DR - K

where CR is the capitalization rate, DR is the discount rate, and K is the expected average growth rate in the income stream. Let's say that the discount rate is 25% and your projections show that the business profits are growing at a steady 5% per year. Then the capitalization rate is 25 - 5 = 20%.

Perhaps the biggest difference between capitalization and discounting is what income input you use. Capitalization uses a single income measure such as the average of the earnings over several years. The discounting is done on a set of income values, one for each year in the projection period.

If your business shows smooth, steady profits year to year, the capitalization method is a good choice. For a growing business with rapidly changing and less predictable profits, discounting gives the most accurate results.

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How business valuation methods can produce different results

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Is it possible to use the income business valuation methods and arrive at different results? Yes indeed! Consider two prospective business buyers doing the income projections and assessing the risk of owning a given business.

Each buyer will likely have a different perception of the risk involved, hence their capitalization and discount rates will differ. Also, the two buyers may have different plans for the business, which will affect how they project the income stream.

Thus, even if they use the same valuation methods the resulting value conclusions may be quite different. Put another way, the two buyers apply the so-called investment value standard to determine the business worth. They measure the business value differently, based on their unique ownership or investment objectives.

This flexibility of measuring the business worth to match one's objectives is one of the greatest strengths of the income valuation approach.

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Adjusting the historical financial statements

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Business valuation is largely an economic analysis exercise. Not surprisingly, the company financial information provides key inputs into the process. The two main financial statements you need for business valuation are the income statement and the balance sheet. To do a proper job of valuing a small business, you should have 3-5 years of historic income statements and balance sheets available.

Many small business owners manage their businesses to reduce taxable income. Yet when it comes to valuing the business, an accurate demonstration of the full business earning potential is essential.

Since business owners have considerable discretion in how they use the business assets as well as what income and expenses they recognize, the company historical financial statements may need to be recast or adjusted.

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The idea is to construct an accurate relationship between the required business assets, expenses and the levels of business income these assets are capable of producing. In general, both the balance sheet and the income statement require recasting in order to generate inputs for use in business valuation. Here are the most common adjustments:

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•Recasting the Income Statement.
•Recasting the Balance Sheet.

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To establish the business profitability potential, you may need to make some normalizing adjustments to the income statement. There are a number of items that frequently require adjustment.

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Owners compensation adjustments
Adjust total owner compensation to the market rate of hiring a manager replacement. Note that the total owner compensation includes the owner salary, bonuses, profit sharing payouts and benefits. Adjust the working family and friends’ compensation to the market rate required to hire a replacement to perform the same function.

Non-cash expenses
Regardless of the depreciation method used, you may need to adjust the depreciation expense to match the true economic value of the business assets.

Inventory normalization
If inventory accounting is reported on the LIFO basis, convert it to the FIFO basis. Simply add back the LIFO reserve which should be available from the financial statement footnotes or the company’s CPA. The FIFO inventory reporting accurately reflects the company inventory costs and is a preferred choice when assessing gross margins.

Business rental expense adjustments
Adjust rents to the fair market rent values. This is important if recorded rent expense is above or below market rates. An example is the business owner renting personally owned property back to the business at above market in order to minimize the taxable income.

Adjust out any non-recurring items
•Factor out the effect of any business interruptions. An example is when the business operations are paused due to facility repairs.
•Factor out amounts from insurance claim proceeds and lawsuit settlements.
•Eliminate any one-time gains or losses from the disposition of assets. An example is selling autos or company owned real estate.
•Exclude gains or losses from business operations that have been discontinued. An example is a closed retail unit.
•Remove abnormally high or low profits. An example is high profit margins due to a temporary spike in demand.
•Factor out one-time expenses such as the business moving expenses.
Unrecorded expenses
Include the actual or potential business expenses that have not been recorded:

•Unrecorded accrued expenses. Examples are staff vacation or bonus pay.
•Check and adjust for bad debt expenses. Examples are uncollectible accounts receivable – check the receivables aging report.
Adjustments for expected future changes
Factor in any potential changes such as an expected loss of a key customer. This should be accounted for in your cash flow projections.

Handling non-operating income and expenses
Remove non-operating income or expense. Examples are non-business real estate income or expenses.

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Recasting the Balance Sheet
The company value depends upon its asset base and the ability of the business assets to generate revenues and profits for the owners. The purpose of recasting the balance sheet is to ensure that the value of assets and liabilities accurately represents the business earning power. There are a number of balance sheet items that may require adjustment.

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Typical asset adjustments for business valuation
Adjust the company assets from their cost-basis value to the current fair market value. A common technique is to determine the depreciated replacement cost of an asset. This is the cost required to replace the existing asset with a new equivalent, minus the adjustment for the time the asset has been in service.

Adjust the business liquid assets such as cash and short-term investments, to the level required to operate the business. Eliminate excess cash from the balance sheet. Account for the additional cash needed if it is below the required levels.

Adjust Accounts Receivable for uncollectible amounts. Review the accounts receivable aging report for proper assessment of the bad debt allowance.

Verify the inventory. Adjust to the current market cost, remove obsolete items, e.g. those that have not sold within the 12 previous months. The inventory should be valued on the FIFO basis since it tends to represent the current inventory value more accurately than the LIFO method.

Adjust any operating real estate to the fair market value. Current real property appraisal is recommended.

Business liabilities adjustments
Some of the business liabilities may also require adjustment from the book value:

Adjust below-market interest debt to current market rates. Assumable payments under such favorable debt financing terms should be discounted at the current market interest rate, which effectively reduces the present value of the liability.

Adjust deferred taxes for timing and amount of income tax payments.

Off-balance sheet item adjustments
Adjust the balance sheet for any off-balance sheet items, such as intangible assets and contingent liabilities. Examples of off-balance sheet assets include intellectual property such as internally developed products. Examples of off-balance sheet liabilities are an impending law suit settlement or regulatory agency compliance costs.

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Choosing the asset based business valuation methods

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Determining the value of an asset-rich company may justify the cost and complexity of the asset-based valuation methods, such as the asset accumulation method. In addition to valuing the individual business assets and liabilities, the method can be helpful when allocating the business purchase price across the individual business assets, as part of the asset purchase agreement.

However, the method requires considerable skill in individual asset and liability valuation which often makes its application costly and time consuming.

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How the market based business valuation methods work

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Market based business valuation methods focus on estimating business value by examining the business sale transaction data available from the actual market place. There are two types of transaction data that can be used:

•Guideline transactions involving similar public companies.
•Comparative transactions involving private companies that closely resemble the subject business.
The advantage of using the public guideline company data is that it is plentiful and readily available. However, you need to be careful when selecting such data to make an "apples to apples" comparison to a private company.

In contrast, reviewing business sales of similar private companies provides an excellent and direct way to estimate the business value. The challenge is gathering sufficient data for a meaningful comparison.

Regardless of which market-based method you choose, the calculations rely on a set of so-called pricing multiples that let you estimate the business worth in comparison to some measure of the business economic performance. Typical pricing multiples used in small business valuation include:

•Selling price to revenue.
•Selling price to business earnings such as net income, SDCF, EBITDA, or net cash flow.
Each pricing multiple is a ratio of the likely business selling price divided by the respective economic performance value. So, for instance, the selling price to revenue multiple is calculated by dividing the business selling price by business revenue.

To estimate your business value, you can use one or more of these pricing multiples. For example, take the selling price to revenue pricing multiple and multiply it by the business annual revenue. The result is the business selling price estimate.

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Valuation multiple formulas

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More sophisticated market based business valuation methods, such as the Rules of Thumb in ValuAdder, use business pricing rules that make an intelligent choice of which pricing multiplies to apply when valuing a business. In addition, the Rules of Thumb let you account for key business attributes automatically:

•Business revenue or profits
•Inventory
•FF&E
•Tangible asset base

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The income based business valuation

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Income based business valuation methods determine business worth based on the business earning power. Business valuation experts widely consider these methods to be the most accurate. All income-based business valuation methods rely on either discounting or capitalization of some measure of business earnings.

The discounting methods, such as the ValuAdder Discounted Cash Flow, produce very accurate results by letting you specify the details of the expected business income stream over time. The Discounted Cash Flow method is an excellent choice for valuing a young or rapidly growing company whose earnings vary considerably.

Alternatively, the so-called direct capitalization methods, such as the ValuAdder Multiple of Discretionary Earnings, determine your business worth based on the business earnings and a carefully constructed capitalization rate. The Multiple of Discretionary Earnings method is an outstanding choice for valuing small established companies with consistent earnings and growth rates.

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The Discounted Cash Flow method results are weighted heavier in the following situations:

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•Reliable business earnings projections exist.
•Future business income is expected to differ substantially from the past.
•Business has a high intangible asset base, such as internally developed products and services.
•100% of the business ownership interest is being valued.

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The Multiple of Discretionary Earnings method gets higher weights when:

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•Business income prospects are consistent with past performance.
•Income growth rate forecast is thought reliable.

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Market based valuation results are weighted heavier whenever:

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•Relevant comparative business sale data is available.
•Minority (non-controlling) business ownership interest is being valued.
•Selling price justification is very important.

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The asset based valuation results are emphasized in the weighting scheme when:

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•Business is exceptionally asset-rich.
•Detailed business asset value data is available.

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Revenues

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The main revenues for Direct Delivery are the fees it earns for delivering parcels. Under the accrual basis of accounting (as opposed to the less-preferred cash method of accounting), revenues are recorded when they are earned, not when the company receives the money. Recording revenues when they are earned is the result of one of the basic accounting principles known as the revenue recognition principle.

For example, if Joe delivers 1,000 parcels in December for $4 per delivery, he has technically earned fees totaling $4,000 for that month. He sends invoices to his clients for these fees and his terms require that his clients must pay by January 10. Even though his clients won't be paying Direct Delivery until January 10, the accrual basis of accounting requires that the $4,000 be recorded as December revenues, since that is when the delivery work actually took place. After expenses are matched with these revenues, the income statement for December will show just how profitable the company was in delivering parcels in December.

When Joe receives the $4,000 worth of payment checks from his customers on January 10, he will make an accounting entry to show the money was received. This $4,000 of receipts will not be considered to be January revenues, since the revenues were already reported as revenues in December when they were earned. This $4,000 of receipts will be recorded in January as a reduction in Accounts Receivable. (In December Joe had made an entry to Accounts Receivable and to Sales.)

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Expenses

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Now Marilyn turns to the second part of the income statement—expenses. The December income statement should show expenses incurred during December regardless of when the company actually paid for the expenses. For example, if Joe hires someone to help him with December deliveries and Joe agrees to pay him $500 on January 3, that $500 expense needs to be shown on the December income statement. The actual date that the $500 is paid out doesn't matter—what matters is when the work was done—when the expense was incurred—and in this case, the work was done in December. The $500 expense is counted as a December expense even though the money will not be paid out until January 3. The recording of expenses with the related revenues is associated with another basic accounting principle known as the matching principle.

Marilyn explains to Joe that showing the $500 of wages expense on the December income statement will result in a matching of the cost of the labor used to deliver the December parcels with the revenues from delivering the December parcels. This matching principle is very important in measuring just how profitable a company was during a given time period.

Marilyn is delighted to see that Joe already has an intuitive grasp of this basic accounting principle. In order to earn revenues in December, the company had to incur some business expenses in December, even if the expenses won't be paid until January. Other expenses to be matched with December's revenues would be such things as gas for the delivery van and advertising spots on the radio.

Joe asks Marilyn to provide another example of a cost that wouldn't be paid in December, but would have to be shown/matched as an expense on December's income statement. Marilyn uses the Interest Expense on borrowed money as an example. She asks Joe to assume that on December 1 Direct Delivery borrows $20,000 from Joe's aunt and the company agrees to pay his aunt 6% per year in interest, or $1,200 per year. This interest is to be paid in a lump sum each on December 1 of each year.

Now even though the interest is being paid out to his aunt only once per year as a lump sum, Joe can see that in reality, a little bit of that interest expense is incurred each and every day he's in business. If Joe is preparing monthly income statements, Joe should report one month of Interest Expense on each month's income statement. The amount that Direct Delivery will incur as Interest Expense will be $100 per month all year long ($20,000 x 6% ÷ 12). In other words, Joe needs to match $100 of interest expense with each month's revenues. The interest expense is considered a cost that is necessary to earn the revenues shown on the income statements.

Marilyn explains to Joe that the income statement is a bit more complicated than what she just explained, but for now she just wants Joe to learn some basic accounting concepts and some of the accounting terminology. Marilyn does make sure, however, that Joe understands one simple yet important point: an income statement, does not report the cash coming in—rather, its purpose is to (1) report the revenues earned by the company's efforts during the period, and (2) report the expenses incurred by the company during the same period. The purpose of the income statement is to show a company's profitability during a specific period of time. The difference (or "net") between the revenues and expenses for Direct Delivery is often referred to as the bottom line and it is labeled as either Net Income or Net Loss.

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Assets

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Assets are things that a company owns and are sometimes referred to as the resources of the company. Joe readily understands this—off the top of his head he names things such as the company's vehicle, its cash in the bank, all of the supplies he has on hand, and the dolly he uses to help move the heavier parcels. Marilyn nods and shows Joe how these are reported in accounts called Vehicles, Cash, Supplies, and Equipment. She mentions one asset Joe hadn't considered—Accounts Receivable. If Joe delivers parcels, but isn't paid immediately for the delivery, the amount owed to Direct Delivery is an asset known as Accounts Receivable.

Prepaids
Marilyn brings up another less obvious asset—the unexpired portion of prepaid expenses. Suppose Direct Delivery pays $1,200 on December 1 for a six-month insurance premium on its delivery vehicle. That divides out to be $200 per month ($1,200 ÷ 6 months). Between December 1 and December 31, $200 worth of insurance premium is "used up" or "expires". The expired amount will be reported as Insurance Expense on December's income statement. Joe asks Marilyn where the remaining $1,000 of unexpired insurance premium would be reported. On the December 31 balance sheet, Marilyn tells him, in an asset account called Prepaid Insurance.

Other examples of things that might be paid for before they are used include supplies and annual dues to a trade association. The portion that expires in the current accounting period is listed as an expense on the income statement; the part that has not yet expired is listed as an asset on the balance sheet.

Marilyn assures Joe that he will soon see a significant link between the income statement and balance sheet, but for now she continues with her explanation of assets.

Cost Principle and Conservatism

Joe learns that each of his company's assets was recorded at its original cost, and even if the fair market value of an item increases, an accountant will not increase the recorded amount of that asset on the balance sheet. This is the result of another basic accounting principle known as the cost principle.

Although accountants generally do not increase the value of an asset, they might decrease its value as a result of a concept known as conservatism. For example, after a few months in business, Joe may decide that he can help out some customers—as well as earn additional revenues—by carrying an inventory of packing boxes to sell. Let's say that Direct Delivery purchased 100 boxes wholesale for $1.00 each. Since the time when Joe bought them, however, the wholesale price of boxes has been cut by 40% and at today's price he could purchase them for $0.60 each. Because the replacement cost of his inventory ($60) is less than the original recorded cost ($100), the principle of conservatism directs the accountant to report the lower amount ($60) as the asset's value on the balance sheet.

In short, the cost principle generally prevents assets from being reported at more than cost, while conservatism might require assets to be reported at less then their cost.

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Depreciation

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Joe also needs to know that the reported amounts on his balance sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by the basic accounting principle known as the matching principle. Depreciation is used for assets whose life is not indefinite—equipment wears out, vehicles become too old and costly to maintain, buildings age, and some assets (like computers) become obsolete. Depreciation is the allocation of the cost of the asset to Depreciation Expense on the income statement over its useful life.

As an example, assume that Direct Delivery's van has a useful life of five years and was purchased at a cost of $20,000. The accountant might match $4,000 ($20,000 ÷ 5 years) of Depreciation Expense with each year's revenues for five years. Each year the carrying amount of the van will be reduced by $4,000. (The carrying amount—or "book value"—is reported on the balance sheet and it is the cost of the van minus the total depreciation since the van was acquired.) This means that after one year the balance sheet will report the carrying amount of the delivery van as $16,000, after two years the carrying amount will be $12,000, etc. After five years—the end of the van's expected useful life—its carrying amount is zero.

Joe wants to be certain that he understands what Marilyn is telling him regarding the assets on the balance sheet, so he asks Marilyn if the balance sheet is, in effect, showing what the company's assets are worth. He is surprised to hear Marilyn say that the assets are not reported on the balance sheet at their worth (fair market value). Long-term assets (such as buildings, equipment, and furnishings) are reported at their cost minus the amounts already sent to the income statement as Depreciation Expense. The result is that a building's market value may actually have increased since it was acquired, but the amount on the balance sheet has been consistently reduced as the accountant moved some of its cost to Depreciation Expense on the income statement in order to achieve the matching principle.

Another asset, Office Equipment, may have a fair market value that is much smaller than the carrying amount reported on the balance sheet. (Accountants view depreciation as an allocation process—allocating the cost to expense in order to match the costs with the revenues generated by the asset. Accountants do not consider depreciation to be a valuation process.) The asset Land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost.

Short-term (current) asset amounts are likely to be close to their market values, since they tend to "turn over" in relatively short periods of time.

Marilyn cautions Joe that the balance sheet reports only the assets acquired and only at the cost reported in the transaction. This means that a company's reputation—as excellent as it might be—will not be listed as an asset. It also means that Bill Gates will not appear as an asset on Microsoft's balance sheet; Nike's logo will not appear as an asset on its balance sheet; etc. Joe is surprised to hear this, since in his opinion these items are perhaps the most valuable things those companies have. Marilyn tells Joe that he has just learned an important lesson that he should remember when reading a balance sheet

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Liabilities

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The balance sheet reports Direct Delivery's liabilities as of the date noted in the heading of the balance sheet. Liabilities are obligations of the company; they are amounts owed to others as of the balance sheet date. Marilyn gives Joe some examples of liabilities: the loan he received from his aunt (Notes Payable or Loan Payable), the interest on the loan he owes to his aunt (Interest Payable), the amount he owes to the supply store for items purchased on credit (Accounts Payable), the wages he owes an employee but hasn't yet paid to him (Wages Payable).

Another liability is money received in advance of actually earning the money. For example, suppose that Direct Delivery enters into an agreement with one of its customers stipulating that the customer prepays $600 in return for the delivery of 30 parcels every month for 6 months. Assume Direct Delivery receives that $600 payment on December 1 for deliveries to be made between December 1 and May 31. Direct Delivery has a cash receipt of $600 on December 1, but it does not have revenues of $600 at this point. It will have revenues only when it earns them by delivering the parcels. On December 1, Direct Delivery will show that its asset Cash increased by $600, but it will also have to show that it has a liability of $600. (It has the liability to deliver $600 of parcels within 6 months, or return the money.)



The liability account involved in the $600 received on December 1 is Unearned Revenue. Each month, as the 30 parcels are delivered, Direct Delivery will be earning $100, and as a result, each month $100 moves from the account Unearned Revenue to Service Revenues. Each month Direct Delivery's liability decreases by $100 as it fulfills the agreement by delivering parcels and each month its revenues on the income statement increase by $100.

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Stockholders' Equity

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If the company is a corporation, the third section of a corporation's balance sheet is Stockholders' Equity. (If the company is a sole proprietorship, it is referred to as Owner's Equity.) The amount of Stockholders' Equity is exactly the difference between the asset amounts and the liability amounts. As a result accountants often refer to Stockholders' Equity as the difference (or residual) of assets minus liabilities. Stockholders' Equity is also the "book value" of the corporation.



Since the corporation's assets are shown at cost or lower (and not at their market values) it is important that you do not associate the reported amount of Stockholders' Equity with the market value of the corporation. (Hence, it is a poor choice of words to refer to Stockholders' Equity as the corporation's "net worth".) To find the market value of a corporation, you should obtain the services of a professional familiar with valuing businesses.



Within the Stockholders' Equity section you may see accounts such as Common Stock, Paid-in Capital in Excess of Par Value-Common Stock, Preferred Stock, Retained Earnings, and Current Year's Net Income.



The account Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset). Another account Retained Earnings will increase when the corporation earns a profit. There will be a decrease when the corporation has a net loss. This means that revenues will automatically cause an increase in Stockholders' Equity and expenses will automatically cause a decrease in Stockholders' Equity. This illustrates a link between a company's balance sheet and income statement.

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The official name for the cash flow statement is the statement of cash flows. We will use both names throughout

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The statement of cash flows is one of the main financial statements. (The other financial statements are the balance sheet, income statement, and statement of stockholders' equity.)

The cash flow statement reports the cash generated and used during the time interval specified in its heading. The period of time that the statement covers is chosen by the company. For example, the heading may state "For the Three Months Ended December 31, 2007" or "The Fiscal Year Ended September 30, 2008".

The cash flow statement organizes and reports the cash generated and used in the following categories:


1. Operating activities – converts the items reported on the income statement from the accrual basis of accounting to cash.
2. Investing activities – reports the purchase and sale of long-term investments and property, plant and equipment.
3. Financing activities – reports the issuance and repurchase of the company's own bonds and stock and the payment of dividends.
4. Supplemental information – reports the exchange of significant items that did not involve cash and reports the amount of income taxes paid and interest paid.

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Because the income statement is prepared under the accrual basis of accounting,

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the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid. You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information. As a result, savvy business people and investors utilize this important financial statement.



Here are a few ways the statement of cash flows is used.

The cash from operating activities is compared to the company's net income. If the cash from operating activities is consistently greater than the net income, the company's net income or earnings are said to be of a "high quality". If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash.
Some investors believe that "cash is king". The cash flow statement identifies the cash that is flowing in and out of the company. If a company is consistently generating more cash than it is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company. All of these are perceived to be good for stockholder value.
Some financial models are based upon cash flow.

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summit partners was started in

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1984

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summit partners vision

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helping profitable companies realize their full growth potential

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summit partners has employees

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We employ more than 85 investment professionals across our three offices in Boston, Palo Alto and London. In total, we employ more than 160 people

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since inception summit partners has raised

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11 billion in private equity and venture capital, and has invested in more than 300 growing businesses across North America, Europe, and Asia

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of the 300 businesses that summit is invested in

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These companies have completed nearly 125 public offerings and more than 115 strategic sales or mergers

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whether a majority or minority stakeholder summit views itself as

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a hands-off growth equity investor that provides strategic guidance to help proven, existing management teams reach their companies’ full potential.

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Summit Partners makes growth equity investments in

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rapidly growing, profitable companies with proven business models, records of revenue and earnings growth, and the leadership capable of sustaining that growth

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the companies that summit partners with are typicallly looking for

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for a partner to help them achieve scale and expand geographically

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summit invests in all industry categories including

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The primary industries in which we have invested to date include business services, communications technology and services, consumer products, education, energy, financial services, healthcare and life sciences, industrial products, Internet and information services, media and entertainment, semiconductors and electronics, and software.

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at summit they believe that great companys are created by

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by great management teams—not by investors

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summits approach to leverage

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We structure investments with little to no debt because excessive interest and principal payments can constrain a company’s ability to grow. However, there are instances where leverage —when used in the correct amounts and for the right purposes—can be a critical part of a company’s balance sheet. In these instances, we can offer subordinated debt financing in conjunction with growth equity

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summits investment size

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We will invest as little as $5 million to more than $800 million per company in combined growth equity and subordinated debt. Our transactions are structured to foster long-term growth, ensure financial stability, and maximize shareholder value. We are currently investing nearly $6 billion worldwide in capital

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summit is currently actively investing in

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four equity and subordinated debt funds that total nearly $6 billion

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summits strategies for growth

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As board members, we have more than two decades of experience providing strategic advice. Summit can help your company build a strong board, complete and develop your management team, as well as source and evaluate acquisitions, joint ventures, and partnerships. We have helped many companies implement best practices in finance, corporate infrastructure, product development, and sales and marketing.

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summits invovlement in a companies board can

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A strong, independent board of directors can help your company analyze its strengths and weaknesses, identify industry trends and emerging markets, and provide complementary knowledge and fresh perspective to your management team. More important, the right board can set the course for your next stage of growth, helping you upgrade your financial reporting infrastructure, identify likely merger-and-acquisition targets and broaden your network in investment banking and lending communities.

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the role of a summit associate

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Associates lead Summit Partners' effort to identify attractive industry sectors and specific companies for investment. They attend tradeshows, review industry journals, develop Summit Partners' proprietary database of private companies, and speak with over 1,000 entrepreneurs each year in an effort to source 2-3 portfolio companies for the firm.

Sourcing deal opportunities for the firm is the most important role of the Associate. Additionally, Associates engage in transactions by conducting due diligence on companies and markets, performing quantitative analysis, and working closely with their specific Transaction Team (generally 3-5 professionals). Secondary responsibilities include helping manage portfolio company relationships

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the three main abilities required of a summit associate

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The three main abilities required are:
technical skills to understand the industries in which the firm invests, analytical
skills to assess investment opportunities, and interpersonal skills needed to build a
strong network which will be a major resource throughout his/her career.

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Associates at summit must have the ability to process

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various kinds of data, interpret the data
effectively and reach a conclusion. The Associate must absorb a lot of information,
determine trends and key issues, and then tactfully raise and address these points
with investment decision makers in the firm. Associates should expect to be judged
on how well they are able to assess the key factors of a deal, whether they make the
right recommendation about the deal and how fast they reach a decision. Beyond
execution, relationship building is extremely important for Associates and is
essential to their long term career success.

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sourcing as an associate at summit primarily involves

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finding deals for the firm through trade shows, tracking local companies and following up on leads generated by partners.

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An excellent question for len

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I have read in a few articles that in contemporary private equity firms upward mobility and promotion to more senior levels within the firm are dependent on the creation of new funds because retooling profit sharing agreements is too messy... is this true at summit and if so how do future fund creation prospects looks presently within the firm.

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What Does Recapitalization Mean?

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Restructuring a company's debt and equity mixture, most often with the aim of making a company's capital structure more stable. Essentially, the process involves the exchange of one form of financing for another, such as removing preferred shares from the company's capital structure and replacing them with bonds.

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Investopedia explains Recapitalization

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Recapitalization can be undertaken for a number of reasons, such as defending against a hostile takeover, minimizing taxes or to implement an exit strategy for venture capitalists. Companies often want to diversify their debt-to-equity ratio to improve liquidity. A good example is when a company issues stock in order to buy back debt securities, thus increasing its proportion of equity capital as compared to its debt capital.

Generally speaking, when a company's debt decreases in proportion to its equity, it has lower leverage and thus, ceteris paribus, its earnings per share should decrease following the change, however its shares would be incrementally less risky, since the company's shareholders have fewer debt obligations which must be paid by the company before shareholders can see profits.

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ten fastest growing industries in the US by revenue

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1 Metals
2 Internet Services and Retailing
3 Oil and Gas Equipment, Services
4 Wholesalers: Diversified
5 Engineering, Construction
6 Construction and Farm Machinery
7 Network and Other Communications Equipment
8 Railroads
9 Aerospace and Defense
10 Pipelines 22.6

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an example of a company that you would look to source

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FTEN --> GETCO

Industry Software
Founded 2001
Growth 2,863.7%
2005 Revenue $407,323
2008 Revenue $12.1 million
Employees 55


enables prime brokers to expand their global sponsored access business by providing a high-frequency execution and risk control platform to support their clients’ high speed trade flow. Integrated with a co-location infrastructure and fresh market data, the platform offers ‘plug and play’ connectivity for fully automated trading strategies, giving hedge funds, prop trading groups, and prime brokers time-to-market and total cost of ownership advantages. Together with unprecedented execution speeds across multiple venues, sponsoring brokers and their clients receive real-time pre-trade and post-trade risk controls along with surveillance reports to continuously monitor positions and limits – without compromising speed.

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an example of a company that is growth

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salesforce.com --> 85% 5yr sales growth --> P/E ratio is 108

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What skill sets are needed in this profession? (len)

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There’s the buying, and the selling…that’s kind of how I bifurcate the job

And by buying, I mean that we are constantly investing in companies that fit our investment criteria. understanding the industry, understanding the business model, getting to know the management team and their skills and prowess, as an operator, these are all very important fundamentals.

On the selling side, the challenge for us is that we don’t necessarily enter into investments where the company needs our money. There’s always a motive for financial transaction, but a lot of the times that we get selected as the investor, its because we have “sold our way” into the company, by convincing the management team, or the founders, or who ever is going to be involved or is currently involved that we are the right partners for them.

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How might I improve my skills to gain entry into this profession? (len)

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a. I think you have to have a good grasp of the mundane aspects of accounting, you know…understanding how financial statements work, how the income statements interrelate with the balance sheet, how that is interrelated with the cash flow statement, I think its pretty vital.

hard skills, a passion to learn, being thoughtful, creative, keeping abreast of current events is good so that you at least have a perspective on how the economy has shifted or evolved over time

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what is the one thing beyond your understanding of financials and interpersonal skills that you can control which ultimately leads to success at summit.

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only controllable thing that I have is how hard I work and how much effort that I put in to the role, and as long as you are constantly focused on giving it your best, that’s all you can really do at the end of the day

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what is the culture at summit really like

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I think that the culture here at Summit Partners and a lot of other firms in private equity is very much a forthright, no-bullshit kind of culture.

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what is the environmnet like at summit partners

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It’s the type of environment where you have to love competition. You have to love to win and succeed, and you have to just love getting on to the playing field and playing as hard as you can.

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what is a deal at summit like

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You find a potential investment opportunity, and the typical process takes between maybe 90 to 120 days from start to finish, and during that period of time, you are just encapsulated within the deal, trying to learn as much about the company as you possibly can, and in order to do that, you’re talking to a whole bunch of people and reading a bunch of articles and news stories, everything you can figure out about that company in that short period of time.

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Because there are no public equity investors the private equity firm's

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financial reporting requirements to all the relevant governmental entities
are reduced. This simplifies management's responsibilities and esults in transaction cost savings for the firm.

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They identify eight factors that are important in
the decision to effect a management buyout. These are:

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1. Potential improvement in managerial incentives
2. Save costs of disseminating information to stockholders
3. Company secrets are better protected
4. Tax savings of interest tax shields and other tax savings
5. Avoidance of hostile takeovers
6. Difficulty to raise capital
7. Illiquid stock (leading to greater difficulty attracting managers)
8. Disagreements among stockholders (because of illiquid in
vestments)