Will appear on BV pages – RECENT VALUATION ARTICLES

Understanding the Value of Intangible Assets

As a follow-up to our recent post on profiting from intangible assets in a business sale, this post introduces intangible asset valuation. As our last post outlined, “intangible assets are identifiable, non-physical in nature. They are something you can describe, document … and, most importantly, transfer.” Once identified, there are several ways to value intangible assets. I’ll discuss a common approach called the “with and without” method, using a simple and recognizable case study.

Let’s say you have a headache and you’re walking down the pain relief aisle of your local Walgreens pharmacy. You see Bayer Aspirin, “The Wonder Drug” to the left and a Walgreens generic bottle on the right. Same ingredients, strength and pill count. However, the Bayer Aspirin is $7.99 and the generic brand is $5.29.

What is the value of the Bayer brand name?

The shopper comparison suggests that Bayer believes that a buyer will pay $2.70 more for a bottle of its aspirin than a generic equivalent. What does this $2.70 represent? In this simple example it represents the premium attached to the Bayer name.  Bayer is able to capture a 34% premium WITH the use of this brand and no premium WITHOUT it. But why?

The Bayer brand has a history that dates back to 1863. They developed the drug in 1897 and sold it under the Aspirin brand name. Only after Bayer’s rights to that brand name either expired, were lost or sold in other countries, did the Aspirin name become a generic descriptor for the drug. This history creates brand recognition and helps the company command a higher selling price than generics to this day.

Why does this all matter? Because the value of the Bayer brand can be determined to be the value of the premium that company is able to generate by owning this brand.

Quantifying brand value is based on the “relief from royalty” concept. This concept suggests that brand value is the value the owner gets by being “relieved” of the royalty payments they would otherwise have to make if they did not own the brand; a more detailed With and Without scenario.

How the numbers work in the Bayer example:

  • Sales: Assume Bayer sold $500 million in aspirin and other related products over the last year. (This is an estimate; Bayer doesn’t disclose sales by product.)
  • Royalty Payment: Assume the Bayer brand, including artwork, colors and logo, can be licensed for 10% of sales. (Bayer has royalty agreements for its various brands but doesn’t disclose specifics.)
  • Royalty Stream of Payments: If you multiply $500 million by 10%, the owner of the brand would generate a royalty stream of $50 million.
  • Long-Term Growth (g): Let’s assume that the growth of this revenue is 3%.
  • Discount Rate (i): Assume, with a stable company and a low interest rate environment that the discount rate (or required rate of return for an investment is this company and therefore its brand) is 10%.
  • Capitalization Multiple: The theory of capitalizing a payment is to multiply next year’s payment by the inverse of its cap rate or as noted above, (i – g) or (10% – 3%) or 7%. The inverse is 1 / 7% or a capitalization multiple of 14.28x.
  • Value of Brand: Assuming the $50 million grows by 3%, the next year’s royalty stream is equal to $51.5 million or $50 million times (1 + 3% growth rate). Value is therefore equal to this next year’s royalty stream times capitalization multiple times 14.28 or $735.4 million.

It may seem strange that the value of a brand that generates only $500 million a year is equal to almost 1.5 times that revenue but if you look at from the point of Bayer, it makes sense. Because Bayer has a “relief from the royalty” payment it would need to make if it did not own the brand, it is able to generate an additional $50 million in value by owning it.  The value of that rising income stream over time is worth a great deal to a stable company like Bayer.

However, if the holding company was smaller and less stable, we would increase the discount rate to reflect that additional risk. Using the above math with a 15% discount rate (an extra 5% of required return to compensate an investor for accepting this additional risk) produces a value of $429.2 million (equal to (i – g) or (15% – 3%) or 12%.  The inverse is 1 / 12% or a capitalization multiple of 8.33x times $51.5 million).  All other inputs are the same except for this risk which has a direct and significant impact on the value.

Think of other intangible assets in the same way.

What would my business be worth if I didn’t have:

  • My customers
  • My supplier relationships?
  • The non-competes with my senior management team?
  • My workforce?

While the approach to valuing these other assets is a bit more complicated, the concepts are fundamentally the same — what is value with and without the asset?

My goal for this blog post was only to introduce this concept. Hopefully reading this didn’t give you a headache. But if it did, reach for your favorite brand of pain reliever! Or for a deeper dive into intangible asset valuation methodologies, read this blog post from the CFA Institute.

*         *          *

Exit Strategies values intangible assets for a variety of purposes including divestitures, mergers and acquisitions, purchase price allocations, financial reporting, corporate restructuring and planning. If you’d like help in this regard or have any related questions, you can reach Joe Orlando at 503-925-5510 or jorlando@exitstrategiesgroup.com.

 

How a Discount for Lack of Marketability (DLOM) is Determined

In a prior chapter of my professional career, I focused on equity security valuations for tax and financial reporting purposes. I led a team of valuation experts who determined the strike price of options granted to employees of up and coming technology companies on their way to IPO. For most, that strike price represents the basis (or cost) of an employee’s future wealth (and tax bill). In simple terms, the valuation of these shares in private companies are based on market multiples (or their value divided by a specific operating metric like sales or earnings) of public companies that are comparable. Once value is allocated to common shares, the per share price is a marketable value because it is based on the stock prices of marketable securities (the publicly traded companies we used to compare). Because private company shares are not as marketable (liquid) as public company shares, we need to adjust for this relative lack of marketability. But how?

Enter the Black-Scholes Model

One answer lies in the economic studies of the early 1970’s. In 1973, Fisher Black, Myron Scholes and Robert Merton published “The Pricing of Options and Corporate Liabilities” in the Journal of Political Economy introducing a simple model with five key inputs. While the formula truly has some high-level calculus, I will try to simplify the output and how it is used.

Here are some definitions you will need to understand before we start:

  • Current Price – The current per share value of the stock.
  • Dividend Yield – The annual return to an investor in the form of dividends as a % of the stock price.
  • Strike Price – The predetermined price.
  • Maturity – The amount of time in years until the option expires.
  • Risk-free Rate – The rate of a return for a risk-free investment, in this case a US Government debt instrument at the same maturity term of the put option
  • Volatility – The rate at which a security increases or decreases over a period of time.
  • Call Option – The option or right to buy (or call) a security at a predetermined price by a predetermined date.
  • Put Option – The option or right to sell (or put) a security at a predetermined price by a predetermined date.

How a Put Option Works

Before I dive into how a Discount for Lack of Marketability (DLOM) is determined, I want to examine a real-life example of what marketability is worth. For my example, I’m only going to look at buying a put option. The purchase of a put option assumes that the buyer is a long-term holder looking to protect his/her position in a security.  I chose a put option because it can be easily compared to an insurance policy.

Facts:

  • Stock Owned: Jane owns 100 shares of Microsoft currently priced at $138.90 as of the close of the financial markets on June 14, 2019. This price very close to its 52 week high of $139.22 per share.
  • Goal: Jane wants to lock in the current price (or close to it) for the next year and is willing to pay for the security of knowing that she can lock in that price.
  • Publicly Traded Options: Jane can buy an put option for one year (or with an exercise price of $140 in June 2020) at $12.20.
  • Options Purchased: Jane purchases 100 put options for $1,220.00 to lock in the sale of her shares when the option expires in June 2020 for $14,000.00.

What this Means for Jane

Jane just bought an insurance policy that lets her get the $140.00 per share for her stock. The put option ensures the marketability of her shares but it came at a cost of 8.7% of the value of her shares (or $1,220 divided by $14,000). While she can’t exercise the option until it expires (the terms of a standard put option) she can sell the options if they increase in value before it expires.

That option will increase in value as the price of Microsoft drops because it is worth more to someone to sell shares at a higher price in the future. An example of this concept is the fact that the put option for the same June 2020 date but at a price of $150.00 is selling at $19.40. In simple terms, the price is driven by the supply (people willing to bet that when the option expires in a year the price of Microsoft will be much higher than it is today) and demand (investors like Jane that simply want protection of believe that the price will be less in a year than it is today).

How this Relates to a DLOM in Valuing Private Company Shares

Let’s replace Jane with Jack and let’s assume that Jack’s investment is 100 shares in Software Widget, Inc., a private company with no publicly traded market for its shares.

Say Jack hires Exit Strategies to value his 100 shares. We value the shares based on market multiples of publicly traded (or “marketable”) companies comparable to Software Widget, Inc. and arrive at a price per share of $50.00 a share. But Jack’s shares aren’t marketable. He can’t call his broker to sell them and certainly can’t buy a put option to protect the value of his shares. Like Jane, he expects the shares to be marketable in a year but unlike Jane, he can’t buy a real insurance policy to lock in that price. Simply put he lacks marketability for the next year but what does this mean to the value we place on his shares?

The answer lies in the put option that we discussed above but instead of looking for the price of one on Google Finance, we need to go back to the formula Black and Scholes determined to build up and calculate a hypothetical one. Using the inputs below highlighted in gray, the hypothetical option asks a simple question; what would it cost to buy a hypothetical put option to lock in the price of a security at $1.00 for one year? In the case of the inputs below, the answer is $0.15 or 15.0% of the value of the security. Because it would cost $0.15 per share to lock in the price of $1.00 over a year, the lack of this marketability is the cost of not having this protection (or to Jane’s example, an insurance policy).

So back to Jack. His shares are worth $50.00 per share on a marketable basis but we need to value them on the non-marketable basis of a private company. Therefore, we apply a 15% discount to arrive at our concluded price of $42.50 as detailed below:

This is just one way to determine a DLOM

In determining discounts for lack of marketability, Exit Strategies also considers studies that map actual discounts of restricted stock. The uniqueness of the put option model approach above lies in the inputs and how the discounts change when one of the three key inputs (dividend yield, maturity and volatility) change. For example, if we change the term above to 5 years, the discount goes to 28%. That increase makes sense because an “insurance policy” to lock in a price would cost more for 5 years than it would for one.

If you have questions about discounts for lack of marketability or if you would like us to value your private business or an equity interest for any purpose, call or email Joe Orlando at 503-925-5510 or jorlando@exitstrategiesgroup.com.

“Closing of the Books” to Allocate Income on S-Corp Ownership Change

As brokers and appraisers of closely-held and family-owned businesses, we work with a lot of S-Corporations. When S-Corp shares transfer subject to a buy-sell agreement, the valuation date, trigger date and transaction date rarely fall conveniently at the end of a year.  That’s no problem for valuation experts. We can determine value as of any date. But what’s the fairest way to allocate taxable income among S-Corporation shareholders in a year in which ownership changes?

The answer, according to Santa Rosa California-based CPA Dan Prince, is to allocate income among the S-Corporation’s shareholders on a per-share basis in the pre-change period and in the post-change period as if the  books were closed on the date of the ownership change. The shareholders agree to make what’s called a “Closing of the Books” election.

Let’s look at a simple example.

Greg and Matt each own 50% of an S-Corp’s shares at the beginning of the year, and on September 30 they both sell 1/3 of their shares to Bud, at which point they each own 1/3 of the shares outstanding. As part of their purchase and sale agreement, they agree to make a closing-of-the-books election.  Assume the Corp has pre-change income of $200,000 and post change income of $100,000, for a total of $300,000 for the year.

Under the Closing of the Books method, the allocation of the year’s income is calculated as follows:

  1. Greg: 50% x $200,000 + 33.333% x $100,000 = $133,333.
  2. Matt: 50% x $200,000 + 33.333% x $100,000 = $133,333.
  3. Bud: 33.333% x $100,000 = $33,333.

The Closing of the Books method is in contrast to the general rule where annual income is simply prorated on a per share per day owned in the change year.  Under this general “proration method”, here’s the income allocation calculation:

  1. Greg: $300,000 x (50% x 3/4 + 33.333% x 1/4) = $137,500.
  2. Matt: $300,000 x (50% x 3/4 + 33.333% x 1/4) = $137,500.
  3. Bud: $300,000 x 33.333% x 1/4 = $25,000.

In practice there’s more to this, but you get the idea.

Business valuation plays an important role in a buy-in, buy-out, buy-sell, redemption, MBO, ESOP or other equity transactions in privately-held businesses.  When you  transfer stock or LLC interests during a tax year, Exit Strategies Group can provide a business valuation but we are not CPA’s. Be sure to consult with your CPA and business attorney for tax and legal advice.

Al Statz is founder and President of Exit Strategies Group, Inc., a business valuation and M&A brokerage firm with offices in California and Portland, Oregon. For further information on this subject or to discuss a valuation or M&A question or need, confidentially, contact Al at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Joe Orlando Joins Exit Strategies; Portland Office Open

Exit Strategies Group, Inc. (ESGI) is pleased to announce that Joe Orlando, ASA, has joined us as Vice President of Valuation Services. Joe will perform the full range of business valuation services for our clients and provide technical leadership to our team of accredited valuation experts.

Over the past 15 years Joe has valued hundreds of early to late stage companies in various industries. Some of his focus areas have been technology (software, ecommerce and online content), wineries, craft beverages and sports. For the past 11 years Joe has led the business valuation practice for Frank, Rimerman + Co. LLP, a large Northern California public accounting firm focused on tax, financial reporting and stock option valuations. Joe’s earlier professional background includes technology investment banking, strategic planning for a public company and multiple entrepreneurial endeavors.

Joe is an Accredited Senior Appraiser (ASA). He has served as President, Vice President, Treasurer and Business Valuation Discipline Director for the American Society of Appraisers’ NorCal chapter, and he is a founding member of the Fair Value Forum. Joe has an MBA in Finance from Georgetown University and a BA in Economics from St. Lawrence University. He lives in Camas WA, across the Columbia River from Portland OR, with his wife and twin boys.

We’ve known Joe as a business valuation colleague and referral partner for years. Joe’s talents, wealth of valuation knowledge and leadership will enable ESGI to expand services to the Pacific Northwest, build our valuation services team, and continue our journey from good to great. With Joe on board, I will return my focus to M&A transaction engagements and supporting our team of seasoned M&A brokers.

Exit Strategies Group is a California-based merger and acquisition advisory and business valuation firm serving lower middle market companies in a variety of industries. We have four California offices and now a Portland, Oregon office. Al Statz is president and founder of ESGI. For further information contact Al at 707-781-8580.

Connect with Joe at jorlando@exitstrategiesgroup.com or 503-925-5510.

Get LinkedIn with Joe.

Financial exit planning, Is your business ready?

I recently had a client looking to sell their medical supply business and retire. I worked with management to pull together all the documentation and financials needed, and conducted conduct a probable selling price analysis. With report in hand I met with our clients to review the results and plan a go-to-market strategy.

Unfortunately, the probable selling price fell slightly short of what the client needed to retire (after taxes). We identified excessive inventory as one of the factors that was limiting enterprise value. How did inventory reduce value and spoil our client’s exit strategy? What can they do resolve this limitation? Read on for the full story.

The company had thousands of SKUs, colors, shapes, types and sizes of medical supplies in inventory. Fully 78% of its assets were in inventory. Current assets exceeded 99% of total company assets. We compared our client’s financials against 10,000+ companies in the industry. The industry was averaging 35 days of inventory on hand (11 turns per year). By comparison our client turned its inventory less than once per year. Keep these figures in mind as we continue.

Cash Flow is King

It’s no surprise that buyers of going concern businesses buy primarily to get returns on their time and money invested. Tying up cash in inventory means less cash to operate or invest in the business (or pay dividends to investors) and increases the risk that you won’t get your money back out of your inventory. But there’s more to this story about how inventory affects value.

The income approach to valuation is based on the concept that a business is worth the present value of its expected future cash flows to its owners. The other approaches to value (market and asset approaches) are also important, but cash flow is ultimately king.

A common income valuation method involves dividing the forecasted net cash flow by a capitalization rate (Cap Rate). The capitalization rate is a function of the expected growth and risks inherent in a company. There’s a lot that goes into calculating appropriate risk and growth rates, but here’s the basic formula:

Value = Net Cash Flow / (Risk – Growth)

Crunching the Numbers

Working Capital = Current Assets – Current Liabilities

  • With minimal current liabilities and high current assets, the company had high working capital requirements.

Working Capital Turnover (Sales / Working Capital)

  • I previously mentioned that the company turns over inventory less than once a year. This suggests either too much inventory or not enough sales, or both.
  • The working capital turnover for this company was an average of 2 (i.e. sales were 2x working capital cost).
  • Industry data showed an average working capital turnover ratio of 7-8.

Net Cash Flow Calculation

  • Net cash flow to equity (NCFe) measures the cash flow to shareholders in a company (equity interest holders).
  • NCFe = normalized after-tax net income + depreciation – less capital expenses – increases in working capital +/- changes in interest-bearing debt.
  • Notice the NCFe formula subtracts increases in working capital. As a company grows, working capital increases, which means less cash for shareholders. For this client, working capital growth reduced cash flow by 25%.

Enough Numbers – Back to Our Story

Our client’s business has a high risk of not selling through years of inventory before that inventory becomes obsolete, expired, lost, stolen or damaged. Therefore, the value from the income approach came in lower than the market approach and asset approach results. In fact, the cost of inventory was higher than the value of the company on a going concern basis. Even in liquidation, the full value could not be realized after the costs of liquidating.

The moral of this story is that a hard-earned business exit can be busted by excessive inventory and inefficient use of working capital. In this case, we advised our client to put their exit on hold for a few years and work strategically to reduce inventory and increase sales. Not only will the reduction in inventory increase future value, but it will also put more cash in the client’s pocket along the way.

If you’re considering a sale and wondering what financial shape your company is in, Exit Strategies’ team of M&A brokers and business appraisers can help you determine value, evaluate strategic alternatives and maximize results.

Michael Lyman CVA is a certified valuation analyst and M&A broker specializing in health care, technology and education fields. With 15 years’ experience working in and building his knowledge in these markets, Michael understands the needs of sellers, buyer and investors. His background includes university positions, two successful e-commerce startups and president/CEO of a small pediatric health care business.

See our related blog post on Managing Working Capital to Increase Business Value.

Ken McCauley Joins Exit Strategies as Senior Valuation Analyst

Exit Strategies Group is pleased to announce that Ken McCauley, CPA, ABV, has joined us a Senior Business Appraiser in our North San Francisco Bay Area California office. Ken will provide a broad range of business valuation services for our clients. He has been appraising businesses since 2010, including wineries, medical and professional services, software, retail, restaurants, manufacturing, construction, and businesses in other sectors.

Prior to joining Exit Strategies, Ken was a partner in AL Nella & Company, LLP Certified Public Accountants in San Francisco California, where he specialized in financial reporting, business valuation services and cash flow analysis for small to medium sized companies. Ken and his partner sold the firm in 2018. Ken’s background includes financial audit experience with a national public accounting firm and multiple corporate finance positions.

Ken holds the Accredited in Business Valuation (ABV) credential and is a licensed CPA. He graduated from the University of Michigan with a BA in Accounting. He has served on the boards of several nonprofit organizations over the years and is currently active on the Stewardship Team at the Center for Spiritual Living.

We’ve known Ken for many years as a client and referral partner. He brings unique talents, knowledge and experience to the ESGI team, and he is great to work with. We are happy to have him help us meet the growing need for professional business valuation and succession planning services.

Contact Ken McCauley at kenm@exitstrategiesgroup.com or 707-823-8440.

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Understanding Seller’s Discretionary Earnings

If you have acquired or sold a small company, or had one appraised, you’ve probably heard the term “Seller’s Discretionary Earnings”. Or you may be thinking “Earnings are discretionary? My earnings aren’t discretionary at all!” Let’s examine this often-misunderstood term, and how it compares to EBITDA, another common earnings measure.

What is Seller’s Discretionary Earnings?

Seller’s Discretionary Earnings (“SDE”) is a calculation of the total financial benefit that a single full time owner-operator would derive from a business on an annual basis. It is also referred to as Adjusted Cash Flow, Total Owner’s Benefit, Seller’s Discretionary Cash Flow, or Recast Earnings. Here at Exit Strategies, we prefer the term Discretionary Earnings or DE. For this article I’ll use the more common SDE.

SDE is most often used in the valuation and sale of “Main Street” businesses. While there is no precise definition of what a Main Street business is, it often refers to owner-operated companies with less than $5 million of revenue. Larger businesses primarily use EBITDA.

SDE vs EBITDA

SDE = Adjusted EBITDA + Owner Compensation (one full-time owner)
Where EBITDA = net Earnings + Interest + Taxes + Depreciation + Amortization.

So SDE is always a larger number than EBITDA. This is a bit counter-intuitive for people used to working in the middle market. They usually think of EBITDA as the large number that things are subtracted from to calculate net cash flow. And wouldn’t SDE be similar to or smaller than EBITDA? A look back at the formula clears this up.

When applying price multiples for sale or valuation purposes it’s important to accurately differentiate between SDE and EBITDA. A mismatch between the earnings measure used and the multiple applied can result in significantly overvaluing or undervaluing a business.

Normalization Adjustments

Once we calculate EBITDA (or SDE) from a company’s profit and loss statement, we need to work through normalizing adjustments. We often break normalizing adjustments into two categories: discretionary items and non-recurring items.

Discretionary Items

Discretionary expenses are those that the business paid for but are really a personal benefit to the owner. Discretionary expenses exist because owners want the “tax benefit” of expensing these items. But they also want the benefit of adding them back into earnings when it comes time to value and sell the business.

Typical discretionary expenses are owner medical or life insurance, personal travel, personal automobiles, personal meals/entertainment, and social club memberships. To qualify as discretionary, each expense must meet all three of these criteria:

  1. Benefit the owner(s)
  2. Not benefit the business or its employees
  3. Are paid for by the business and expensed on tax returns and P&Ls

Whether an expense is discretionary or not isn’t always obvious:

Definitely AdjustDon’t AdjustGray Areas
Retirement plan contributionsNetworking group membershipsTravel (business and pleasure)
Home landscapingMarketing expensesContributions

Discretionary expenses are often the subject of debate between a buyer and seller. Buyers, of course, are risk averse and dubious about all these co-mingled expenses the seller claims are “not really expenses.” Items that fall in the gray area will require extra documentation by the seller and due diligence by the buyer. Certain items that a buyer might accept won’t be accepted by a bank. Generally speaking, sellers will benefit from stopping all commingling of business and personal expenses at least three years before they sell a business.

Non-Recurring Items

The other major category is extraordinary/one time income or expenses. Adjusting for extraordinary one time income and expense makes sense because they are not expenses that are indicative of the core business operations. Common examples are restructuring costs, costs related to acts of nature, asset sales, litigation expense and emergency repair costs.  One-time expenses are also scrutinized and debated. Did that bad debt really only happen once? Or is it likely to occur again in the future?

Why is this important?

In M&A transactions buyers are concerned about risks: What aren’t you telling them? How could this investment go bad? We often say that getting to a closing is about removing roadblocks in the deal – and often the biggest among them is reducing the buyer’s level of perceived risk. With that in mind it’s important to think about the line items that go into SDE well before you go to market and do your best to reduce any areas that might fall into the “questionable” zone. The cleaner your financials are the more likely you are to sell on the best price and terms.

Bob Bates, CPA, CVA is a senior valuation analyst in Exit Strategies Group’s San Jose California office. For more information on the use of earnings and cash flow measures used in business valuation, or to discuss a current business valuation need, Email Bob at bbates@exitstrategiesgroup.com or call him at 408-769-4404.

Manage Working Capital to Increase Business Value

As you likely know, working capital equals current assets minus current liabilities. Companies that have a high level of cash tied up in current assets (primarily cash, accounts receivable, and inventory) without similar levels of current liabilities are not as attractive as those who tightly manage their working capital. Buyers are often leery of businesses that require high working capital to sales ratios because as sales grow the company must continually invest more cash in working capital. Conversely, companies with low working capital can grow faster and return more cash to shareholders as they grow.

One Recent Example

We were recently retained to do a fair market value business valuation of a multi-state, value-added industrial distribution company for a shareholder buyout. The company was a profitable going concern. While it showed modest EBITDA margins, its working capital requirements were unusually high, primarily due to extraordinarily high accounts receivable and inventory levels.

A prior valuation done not long ago for a different purpose had relied solely on an Asset Approach method. Specifically they used the Adjusted Book Value (ABV) method where all assets and liabilities are marked to market. Thanks to the company’s high current assets combined with almost no current or long-term liabilities, the result was a high valuation number. As part of our analysis, we naturally considered the prior valuation. We wondered how valid its conclusion was from the perspective of a hypothetical buyer of a going concern business who would be concerned with future cash flows.

Following standard business valuation practice, we considered the three approaches to valuation: asset, market and income. The asset approach using ABV gave results marginally higher than the prior valuation while the market approach (comparable asset transactions method) values were slightly lower. However, when we analyzed the income approach using a single period capitalization method (SPCM), our result was substantially lower than the asset approach. Why? Because the SPC method is based on capitalization of net cash flow to equity holders, which considers changes in working capital that are largely ignored by the asset and market approach.

We were compelled to give some weight to the income approach results as we believe knowledgeable buyers of shares in the company would have a strong  interest in their expected return on investment. The result was a valuation conclusion somewhat lower than adjusted book value.

Theory Holds True in Practice

I want to point out that this affect of working capital on enterprise value isn’t just abstract financial theory. We regularly see it play out in actual M&A transactions where buyers have no interest in paying more for companies with higher working capital. And we often see sellers rewarded (sell for higher earnings multiples than their industry peers) for having proven that they can operate effectively with less working capital.

It is also interesting to note that in this case, should the owners of the company have tried to liquidate the company’s assets to generate cash, the net amount yielded would have been substantially less than adjusted book value. Given that the company had no plans to liquidate, we didn’t consider using a liquidation value.

What Companies Should Be Doing in this Area

Company owners and management should constantly reevaluate and consider modifying their accounts payable and borrowing practices, as well as focus on ways to reduce accounts receivable and inventory requirements. All of which will reduce working capital, generate cash, enable faster growth, and increase shareholder value. Sometimes this even means making tough decisions like firing a customer or replacing a key vendor.

For further information on how working capital affects enterprise value, or to have a business analyzed for sale, acquisition or exit planning purposes, contact Jim Leonhard, CVA MBA  at 916-800-2716 or jhleonhard@exitstrategiesgroup.com. 

One Business Appraiser that All Parties Know and Trust

Jointly retaining a single trusted business valuation expert in disputes over value is becoming increasingly common as owners seek ways to streamline the valuation process, protect their companies and control costs. Naming one appraiser in buy-sell agreements is also becoming more popular. In this slightly long-winded rant, I will discuss the pros and cons of using one appraiser that all parties know and trust, and explain why you should give serious consideration to this option.

Where My Thought Process Started

Exit Strategies has provided valuation services for many California companies going through involuntary dissolution processes.  Involuntary dissolution proceedings, per California Corporations Code § 1800 and § 2000, give minority shareholders who feel they have been victimized by those in control to force a liquidation or sale of the company, unless the corporation or its majority owners agree to buy them out at fair value.  CCC § 2000 stipulates that, “The court shall appoint three disinterested appraisers to appraise the fair value of the shares …”. Often, the judge in these cases requires that the appraisers work together to develop a conclusion of value.

What’s interesting to me is that in every CCC § 2000 case where I worked collaboratively with other competent appraisers from start to finish, we were able to reach agreement on a conclusion of value.  I’ve talked to several other BV experts who have similar experiences on such panels.

So, why do appraisers, working separately, reach different values?

I see three main reasons why Qualified (experienced and professionally accredited) valuation experts selected by opposing parties and working in isolation from each other are more likely to conclude different values for the same business:

  1. They have different facts. They ask different questions about the company, often of different people with different agendas, Then, using different information they arrive at different conclusions. Makes sense, right? Conversely, when appraisers receive the exact same inputs on a company, they are far more likely to produce similar values. If you hire multiple appraisers, be sure that they all get the exact same information.
  2. They head off in different directions.  Subtle differences in scope of work can have substantial effect on reported values.  Appraisers using different standards or levels of value are guaranteed to report different values.  It’s also common to see different valuation dates used.  Or, one appraiser reports a value of equity and another reports an undefined asset sale value. Often, the clients don’t even know this is happening.  And the appraisers don’t know because they are working in isolation. Such differences in direction are best identified and resolved in advance.
  3. Bias. Even though appraisers are supposed to be impartial, some succumb to pressure to deliver a result that favors the party that selected them or satisfies the attorney that hired or referred them. Exit Strategies’ professionals assiduously avoid letting bias creep into our valuations. (M&A advisory is a different story. There we absolutely advocate for our client.)

Now, CCC § 2000 cases are fairly infrequent, and usually the parties decide how many appraisers to hire. As this point you may be thinking, “wait a minute, doesn’t each shareholder need to have their own appraiser?” Let me turn that question around…

If a panel of appraisers working together generally see eye-to-eye, why have more than one?

The main argument for having multiple appraisers (besides putting more appraisers to work!) is that it can guard against an outlier opinion or one appraiser making an honest mistake. If you are careful in selecting the appraiser, however, you can mitigate these risks.

Cost is an obvious disadvantage to having multiple appraisers. Not only do the parties have to pay for 2 or 3 valuations, but appraisers generally charge more when they know they’ll be working in an antagonistic and uncooperative environment or when they know their report is likely to be challenged in litigation. The reason; more hours of work.

One very important disadvantage of hiring multiple appraisers is the deleterious effect it can have on shareholder relationships and the company itself. The perception of having an appraiser in their corner promotes divisiveness between owners. They become suspicious of the other expert(s). And doubling or tripling the number of information requests, interviews and follow up questions increases management’s workload, distracts them from running the business, and prolongs the valuation process. As the rift between owners grows and the company drifts, value erodes for all shareholders.

This seems to be a good point to summarize the advantages of a using single, jointly-retained business valuator — lower cost, less work and distraction for management, better shareholder cooperation, reduced likelihood that information will be withheld or biased, less danger of advocacy, and scope of work clarity. Next, let’s discuss how you go about selecting and working with a joint BV expert.

Keys to Success with a Jointly Retained Business Valuation Expert

  1. Get to know the expert. Establish trust between all parties and the appraiser at the outset. Start by requiring professional valuation credentials, several years of relevant BV experience and real-world business transaction expertise (not just financial theory). Ask around for recommendations. Jointly interview appraisers until you find one that you are all comfortable with.
  2. Correctly define the engagement, i.e. standard of value, subject interest, level of value, scope of analysis, type of report, valuation date, etc. Many buy-sell agreements and jurisdictions do not have well-defined valuation criteria. A trusted and Qualified BV expert can point out the various interpretations and work with the parties and their legal advisors to reach a consensus. Or the parties can have the appraiser produce multiple values using different interpretations, often for little extra cost.
  3. Require open communication. Set ground rules to involve all shareholders, and advisors (attorney, CPA, etc.) in some cases, in all communications with the valuation expert throughout the process. Shareholders should have access to all information requests and documents provided, be copied them on emails, be invited to fill-out and review questionnaire responses, be invited to all live interviews, presentations and meetings, and be given the opportunity to review and give feedback on a draft valuation report.

Getting to Trust an Appraiser

Successful jointly-retained experts have integrity and strong interpersonal skills. Get a sense of who they are by looking at their website and LinkedIn profile. Are they transparent and forthcoming with information? Can they write? Are they involved in their community and do they give back to their profession? Etc. Someone from a pure litigation support firm with little or no digital footprint probably isn’t right for this job.

In our experience, when we are jointly-retained, the parties are naturally more open and honest about company strengths/weaknesses, risks and future prospects. Separate experts rarely get the full access 360-degree view that a single expert with the support of all parties gets. In turn, they do better work and trust in them grows.

There is perhaps no better way to decide if you can trust someone than to work on a project together. If you know you’ll need an appraiser to set a share price for an imminent buy-sell transaction, don’t wait for the trigger event. Select an appraiser now and go through the valuation process together while there’s less at stake. You and your stakeholders will get to know the appraiser and the quality of their work. Further, the appraiser’s knowledge of the company and its industry will grow and they can probably recommend strategies to enhance the value of your company, which benefits all shareholders and more than pays for the extra appraisal.

What Business Owners Can Do

The next time you need an accurate unbiased business valuation or are preparing shareholder agreements, think about using a single Qualified BV expert that all parties know and trust.  Feel free to call us to discuss your needs and circumstances, or ask your attorney to contact us, in total confidence. We will let you know if we think this is good option for you.

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Valuations play a part in all strategic transactions, tax, and many litigation matters.  Al Statz is President and founder of Exit Strategies Group, Inc. which has four California offices and has been selling and appraising businesses since 2002. Al is an accredited business appraiser (ASA and CBA) and a Merger & Acquisition Master Intermediary (M&AMI).  For additional information or advice on a current situation, please do not hesitate to call Al at 707-781-8580 or Email.

Business Valuations Can Create Value, Not Just Report It!

I recently completed a valuation engagement for two shareholders of a California manufacturing company who were going through a buy-sell transaction. After the sale, the buying shareholder called to tell me how my valuation report gave him the confidence he needed to complete the purchase, take on debt, and revamp the company’s business plan. Besides making my day, his call made me think about why almost every business owner can benefit from a valuation.

When all aspects of a business are objectively analyzed by an independent, experienced business valuation professional who then considers each detail (after all, valuation is both art and science), applies real-world valuation approaches, and produces a well-documented report, you receive invaluable information for making important business and investment decisions.

If you’ve had your business professionally appraised, you know what I mean. If you haven’t, you are missing out on more valuable and actionable insights than you probably realize.

Why do business owners and others have businesses valued?

Some of the most common reasons include:

  1. To get an idea of how the market would value a business
  2. To create a process to increase a company’s marketability
  3. Click here for 50 Reasons for a Business Appraisal

For further information on buying, selling or increasing the value of a business, or business valuation or appraisal, you can contact Jim Leonhard, CVA MBA at 916-800-2716 or jhleonhard@exitstrategiesgroup.com.