Will appear on BV pages – RECENT VALUATION ARTICLES

Business Interruption 101

If you are reading this blog post from the Left Coast today, you know all too well the front page pictures and stories on the wildfires affecting Northern and Southern California in the past few weeks. The devastation is unimaginable.

As I write this, the Kincade Fire in Sonoma County (just north of our Petaluma office) is 60% contained and 76,825 acres have burned. In local terms, that is about the size of San Francisco plus a little bit of Burlingame near SFO airport. On the East Coast, it’s roughly the size of Washington, DC from Alexandria, VA to north of Chevy Chase, MD.  While the fire has destroyed almost 300 structures so far, we are lucky that no lives have been lost and there have been minimal injuries.

No Power, No Business…Maybe

For local businesses, it has either been boom or bust, not only from the fires but the local utility’s response to fire prevention, specifically shutting off power throughout the Bay Area. As the affected population moves towards the communities with power, people are dealing with a new way of life during a difficult time.

In Petaluma, which is located just outside the mandatory evacuation zone and has had minor power outages, business has been booming. Restaurants have been overflowing with displaced evacuees from the north. Hardware, department and grocery stores have been full of people looking to replace essentials. Meanwhile communities without power have experienced a bust. One local market is experiencing heavy uninsured financial losses from losing power. A local catering company may lose up to $150,000 in revenue if they can’t reopen in time for this weekend’s wine country weddings.

Insurance for a Dark Day

Business interruption insurance is a form of commercial damage coverage that covers the loss on income that a business suffers after a disaster. Business interruption occurs when the event, such as the Kincade fire, affects revenue and/or cost and profit is lost. Other events include natural disasters, movement from temporary sites to a permanent site, and/or Government actions causing it to cease operations.

In each of the events mentioned above, one thing is common. Revenue is being missed and expenses continue. The company bears the initial burden of the expenses but insurance or litigation can help business owners get through this loss and remain profitable after recovery. If the interruption to the business was caused by a third party (in this case, the power utility), litigation would be carried out through subrogation (or the assumption of debt or damages to a third party) to recover the losses. This situation would mean that the insurer pays the claim initially then goes after PG&E or another party that caused the event and therefore the loss.

How to Calculate the Loss

Whether it is insurance, litigation, arbitration or settlement, covering your business interruption expenses can be challenging. We have handled the expert/calculation side of these type of engagements in valuing the losses/lost profits.

Many losses fall into three areas:

  • Service Interruption – This impact could be direct damage, physical loss, destruction to utilities, services, telephone, transmission lines, substations, equipment of suppliers of such services as well as related plants.
  • Business Interruption –Here, the property damage to the receivers or suppliers is typically covered by the insurance policy.
  • Restoration – These are expenses incurred during the length of time that is required to replace, repair, or rebuild the damaged property, starting from the point the damage occurred.

The value impact is effectively the difference between a “with/without” analysis where the “with” relates to the actual financial performance as a result of the interruption and the “without” is related to the operations of the business without the interruption based on historical performance. In addition to the matter of recovering costs, extraordinary events or “acts of God” can affect the valuation for a business, either temporarily or permanently.

Our New Normal

In the case of Northern California, the local utility has already let customers know that the “new normal” will be one of power blackouts and a bag packed with emergency supplies. It may take Pacific Gas & Electric 10 years of blackouts before they can make their infrastructure more immune to weather events. PG&E even has its own marketplace for generator sales. Yes, the irony is not lost on us. With increased migration out of California, these fires may be the tipping point for some families who just can’t afford to accept these risks.

Hopefully reading this blog post doesn’t scare you away from visiting California, in particular the beautiful wine growing regions of Sonoma and Napa counties. Like a good Boy Scout, you just need to be prepared for our new normal and share the beauty of our part of the world with the friendly and increasingly resilient locals who call this place home.

Exit Strategies values businesses and 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 Bob Bates, CPA, CVA, CFE at bbates@exitstrategiesgroup.com.

California’s AB5 Law May Impact Small Business Values

Adam Wiskind, CBIAssembly Bill 5 (AB5), signed into law last month by governor Gavin Newsom, will impact the valuation of many small businesses in California that have grown to depend on independent contractors.  For impacted owners intending to sell in the near term, this new law may require a change of plan.

The new law, which goes into effect on January 1, 2020, creates an explicit three-part test for whether a worker can be classified as an independent contractor.  A worker can only be considered an independent contractor if:

  • (A) the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact; and
  • (B) the worker performs work that is outside the usual course of the hiring entity’s business; and
  • (C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

AB5 exempts many occupations including doctors, dentists, lawyers, engineers, architects, accountants, real estate agents, travel agents, graphic designers, human resources administrators, grant writers, marketers, fine artists, investment advisors, broker-dealers and salespeople provided their pay is based on actual sales, rather than wholesale purchases or referrals. However, many small businesses in California that regularly employ independent contractors for work that is within the usual course of their business are not exempt.  For these businesses reclassifying workers could add as much as 30% to labor costs.  Labor intensive service businesses will be most impacted. Court reporting, janitorial and delivery services are typical examples.

Valuation Impact

Non-exempt California businesses that have to reclassify independent contractors to employees will likely see a contraction in enterprise value as buyers (and banks and appraisers) apply the expected increase in labor cost to proforma financials and guess at how much of the increased cost can be passed along to consumers. As businesses in a particular non-exempt industry convert from independent contractors to employees, the competitive playing field will be re-balanced.  Some who choose not to comply will go out of business. Those who already comply could see an increase in business, and value.

Owner Options

Business owners are considering their options to respond to the new law and its impact on valuation, including:

  1. Mount legal or policy challenges – The major gig-economy platform companies will challenge the law and small businesses may follow suit.
  2. Relocate work outside California – Can work currently being done by local independent contractors be transferred to contractors outside of California?
  3. Ignore the law – Some owners will no doubt continue with business as usual in the hopes that they don’t face a legal challenge.
  4. Reclassify workers and absorb the additional costs – The new law will raise costs for those who reclassify workers, and likely for the consumers of their products and services. There is a lot to consider here.  Which workers should be reclassified?  How will worker roles change? What are the cost implications?  How will these changes impact supervision, accounting, compliance and insurance requirements? Will the change result in a more committed and productive work force?

Regardless of how they respond, business owners who have spent years building their businesses under an independent contractor model and are impacted by AB5 are at crossroad. Hopefully this article raises awareness of the issues and helps some owners evaluate their options. If you are one of these owners, be sure to get professional legal and HR counsel.

Adam Wiskind is an M&A advisor at Exit Strategies Group and is a Certified Business Intermediary based in Sonoma County California.  If you are interested in better understanding this topic or in selling a $1-50 million revenue California business, contact Adam at awiskind@exitstrategiesgroup.com.

Ten Factors that Affect the Cost of a Business Valuation

In the world of pricing, there are simple models (e.g. cost plus a profit markup) and complex models (e.g. dynamic pricing based on real time supply and demand algorithms ). If you have ever purchased an airline ticket online, you’ve seen how a complex model makes prices impossible to decipher. Fortunately, we can offer greater transparency and consistency on business valuation pricing!

Like most professional service pricing models, business valuation pricing is largely a function of the time it takes to do the work. The amount of work involved is driven by the following factors.

Ten Factors that Affect the Cost of a Business Valuation

  1. Normalization – Most income statements and balance sheets of owner-operated businesses require normalization (adjustments). There are often discretionary and non-recurring expenses to adjust. Owner compensation needs to be investigated and adjusted. Commingled personal expenses and related-party business expenses must be evaluated. Operating assets need adjusting to market values. Non-standard and tax-driven accounting decisions may need to be “undone.”  How long all this takes depends on the nature, structure and accounting practices of the business. Sometimes it takes us 10 minutes, other times 10 hours!
  2. Non-Operating Assets – Some businesses own assets that are not required to run the business. For example, a vacation home or personal vehicles. Or equipment that is no longer used. Or real estate owned by a business that can be removed and rented back. We adjust the balance sheet and cash flows for these items. We may need to separately value these assets or find a specialist to do so.
  3. Due Diligence – Some businesses are easy to unravel and understand. Others require a deeper dive. Ultimately, we need to understand the business model, how the company compares to industry peers, and its future outlook and risks. Getting up to speed requires independent research and time with the CEO, CFO, CPA or others.
  4. Forecast Complexity – Without access to a long-term financial forecast, we may need to develop one. Is the company at a steady state and if not, what amount of visibility does management have on the future of the business?
  5. Industry Niche – Businesses come in all shapes, sizes and flavors. Those that compete in a narrow industry niche that isn’t covered by research firms require us to do custom independent research to evaluate market opportunity and industry outlook.
  6. Intended Use and Users – The purpose of a valuation affects standard of value, scope of analysis, due diligence and reporting, which affects the amount of appraiser time required. Our website discusses the various uses of business valuations.
  7. Standard of Value – The standards of value for tax, financial reporting, shareholder oppression, marital dissolution and strategic acquisition are all different, and some are easier to work with than others. This one relates back to intended use.
  8. Valuation Date – Performing a valuation as of some long-passed historical valuation date requires more due diligence to evaluate market conditions and decide what was known and knowable as of that date. And when a client or their CPA or attorney change the valuation date on us midstream, that adds hours.
  9. Interest Valued – Minority interests usually have to be discounted for lack of control and marketability, which requires extra analysis and reporting. Valuing interests in companies with complex capital structures (preferred or convertible shares) also requires extra work.
  10. Timeliness and quality of information – This factor is simple but important. When we receive data quickly that is clear, accurate and concise, our work goes faster. When we have to chase people for information or follow up every answer or document with more questions and requests, projects take longer. Having to put down and pick up a project multiple times because we’re waiting for information is also a big time waster.

How We Price Valuations

At Exit Strategies, our goal is always to provide the right level of service (no more, no less) at a fair and competitive price. We start every potential engagement with a discussion on these 14 topics that helps us understand your needs and propose the appropriate valuation service. A valuation that uses the wrong standard of value for example may be cheap, but useless. You’d be surprised how often appraisers get this wrong.

We quote a fee range for most of our business valuation work. In all cases we endeavor to work as fast and affordably as possible. If you have been quoted a fixed fee for a business valuation, be careful. There’s a good chance that appraiser will use the same cookie cutter methods and spend the same amount of time on your valuation no matter what they find along the way, which is probably not in your best interest. Be sure to get what you need.

Exit Strategies values businesses for a variety of purposes including divestitures, mergers and acquisitions, buy-sell, business divorce, financial reporting, corporate restructuring and exit planning. If you have questions or need a business valuation, contact Joe Orlando at 503-925-5510 or jorlando@exitstrategiesgroup.com or Jim Leonhard at 208-912-0455 or jhleonhard@exitstrategiesgroup.com

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.

Get LinkedIn with Ken.

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.