Financials 2011

Owning a closely-held business can be unnerving. Particularly so when you have the majority of your personal net worth invested and times are tough and uncertain. More than ever, owners are seeking tools to help measure the returns on this investment and to make sure that they are being properly compensated for the risk.

Unfortunately, the process is not so simple for owners of security alarm companies, as the industry has a somewhat unique combination of operating and financial dynamics that can make it difficult to quantify precisely what is the "investment" and what is the "return."

Defining the return/investment

While many recurring revenue-oriented businesses have the same fundamental dynamic as the security alarm industry, whereby losses are incurred in the process of originating new customers in exchange for long-term contracts for high-margin services, the proportions of this activity and the lack of a standardized accounting treatment for the origination costs are somewhat unique. The result is that some relatively material distortions can occur around traditional financial indications associated with value and returns. This can be seen when noting that the same group of originated customer accounts can receive dramatically different accounting treatments if generated internally and completely expensed, versus having been acquired and completely capitalized. In most cases, particularly in the short term, the acquisition treatment will yield much better traditional financial results even if the cost is much higher. Growth can have an equally distorting effect with higher growth companies typically showing poorer traditional results, especially when the growth comes through internal sales.

Given this, it is necessary to seek alternative, more industry specific approaches, where both the operating dynamic of the business is accommodated and value is appropriately ascribed to the recurring revenues independent of the accounting for the origination costs. Broadly speaking, owners realize returns on their investment in three components. The first mechanism is through the enterprise increasing the value of the shares. This increase is typically realized through the execution of the basic business proposition: create value by originating or acquiring customer accounts at a cost below the present value of their long-term, high-margin recurring revenues. While the balance sheet provides precise indications of liabilities, the account base, which is typically the largest asset of the company, is rarely reflected at a proper value. Luckily, the industry has a highly standardized and documented approach to expressing this value, through the use of a multiple of the monthly amount of the recurring revenues (RMR). While hardly perfect, it represents a useful and simple benchmark. Using a reasonable multiple of RMR to value the operations and then subtracting all liabilities gives a quick, clean view on the value of shareholder equity, with any changes from one year to the next defining the first component of "return."

The net change in invested cash is the second component and represents the difference between dividends or distributions paid during the period measured and any additional cash invested by the shareholders during the same period.

Returns specific to the industry

The third component of "return" is associated specifically with owner operators. It is the net benefit derived by the investor as a result of the employment opportunity associated with the investment. This can be in the form of specific benefits, such as having higher total compensation and perquisites than the market value of the management services provided, or more amorphous benefits such as the quality of life issues associated with being one's own boss. These are often overlooked and yet are very real. They can be negative in value, as compensation can be below market levels, and/or the stresses of self-employment can be costly.
Using this approach, the total return is defined as the sum of the three components:

RETURN = Share Value Increase + Change in Invested Capital + Owner Operator Benefit

Often, it is assumed that the "investment" should equal the amount of capital paid in by the owner/investor. When businesses are first starting, this can be appropriate, but quickly this number loses its meaning. After all, one is not just risking the paid-in capital if it has materially appreciated. A good way to think of this is to contemplate receiving property willed to you, which was purchased for pennies in the early 1800s, but now is worth several million dollars. Which would be most relevant when thinking of your investment portfolio, the purchase price or its current value? Put another way, you buy the shares you own every day at the market price you forgo. This "marking to market" concept is critical to quantifying the true "investment."

As mentioned earlier, the security alarm industry routinely uses a multiple of RMR to express the value of companies and/or accounts that have traded. While values have fluctuated over time, the market has generally traded most consistently in the 30s as a multiple of RMR. While it is possible a given company could, or should be valued higher or lower, the use of this valuation range should be the place to start when seeking a conservative multiple applicable over time.

In order to complete the approach, an adjustment needs to be made for three assets typically addressed outside of the multiple ("Other Assets"): 1.) cash or cash equivalents; 2.) accounts receivable; and 3.) inventory. From this total asset value calculation, all liabilities are then deducted in order to quantify the value of the equity shares. Written in the same formulaic fashion:

INVESTMENT = (RMR x Multiple) +
Other Assets - Liabilities

Using the approach outlined, here is an example company illustrated over the last three years, with the valuation multiple equaling the 35x mid-point in the range indicated in the accompanying chart. As shown, this company increased the value of its equity from $1.6 million at the end of 2007 to $2.1 million by the end of 2010, with its owner operator contributing an additional $50,000 in capital in 2009.

Are the returns high enough?

This is a tough question. By comparison and depending upon the timeframe considered, long-term average annual returns for investing in the stock market are roughly seven to 12 percent. Investment theory would suggest this owner operator should receive a premium over these returns for investing in such a small company, where there is no liquid market for the shares.

On the other hand, this investor knows the business intimately and has complete control over the decisions made by the enterprise. Additionally, the stability of the industry and this company's performance is impressive, as is the relatively constant market for the selling of companies of this size.

While many companies we have reviewed generate returns higher or lower than those reflected above, this range is what we tend to see most often. Additionally, the vast majority of these investors are staying the course, which suggests that there is at least some consensus that these return levels offer adequate compensation for the risk.

Using tools such as those outlined above allow owners to gain a view on how their investment is doing and also potentially point to ways in which they can improve their returns.

Michael Barnes is a founding partner of Barnes Associates Inc., a consulting/advisory firm specializing in the alarm industry.