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Will appear on BV pages – RECENT VALUATION ARTICLES
Increase Business Value with Agreements
- Facility lease
- Client contract
- Construction contract
- Equipment lease
- Supplier contracts
- Distribution agreement
- Employment agreement
- Independent contractor agreement
- Non-competition agreement
- Collective bargaining agreement
- Financing of various kinds
- License or royalty agreement
- Franchise agreement
- Advertising agreement
- Joint venture agreement
- Others specific to your business
Tip for Maximizing Business Value: Diversify Your Customer Base
- They get lower pricing from a domestic or foreign competitor.
- They bring production of your product or service in house.
- Their parent company shuts down the division that you’ve been supplying, or relocates it outside of your service area.
- They acquire one of your competitors, who becomes their preferred supplier.
- Or, they are acquired, and the parent has another preferred supplier.
- Your key contact person retires; new management doesn’t have the same loyalties and may prefer another supplier.
- Products run their course; the next generation product will no longer use the component you’ve been supplying all these years.
- The company changes strategic direction and no longer needs your products or services.
- Any number of other business motives and external circumstances beyond your control!
Related Party Transactions in Valuation
I was recently engaged to value a client’s interests in two businesses. These two businesses had several shareholders in common, and the businesses were doing business with each other. We refer to these as related parties and related party transactions.
Our client’s ownership percentages were different in each business, so we were concerned with whether transactions between the companies were priced at market, versus prices that unfairly benefit one or the other business. I investigated these transactions and adjusted them to market. Had I not done so, the value concluded for each business would have been different, thereby affecting the total value of our client’s holdings.
Some of the transactions between related parties that we frequently find and investigate for arm’s length terms include:
1. Lease rates for facilities and equipment owned by one party and used by the other
- Has the rent been at, above or below market value? Has rent followed a consistent pattern? Is there a valid lease? Are the terms and conditions similar to market, and are they being honored? Market rates must be determined through research.
2. Pricing on products sold by one company to the other
- Is transfer pricing at market value? If not, both party’s operating profits could be unfairly stated. Is there a contract between the companies detailing pricing terms? If pricing is non-market and no contract exists, a value analyst has difficulty forecasting future revenues and cost of goods.
3. Administrative, marketing and other fees paid by one company to the other for services provided
- Can the providing company document the services provided and amounts charged to the other party? When such documentation isn’t unavailable, the analyst must rely on management representations as to the validity of the fees. Is there a written agreement between the businesses detailing services and pricing? Absent documentation and guidance from the parties and without an agreement to rely on, the analyst is forced to assume that such fees have been, and will be, calculated accurately, fairly and consistently.
4. Fees for intellectual property licensed by one company to the other related company
- Common examples of licensed IP are trademarks, software and product designs.
5. Receivables/payables and loans to/from related parties
- Loans to related parties may be reclassified as non-operating assets. Loans from affiliates may need to be reclassified as long-term debt, or equity if there is little chance that such loans will be repaid. Related party receivables may need to be discounted to market value or eliminated, depending on their economic substance.
In each of the above cases, market rates are determined either by observing prices between the business and unrelated suppliers and customers, or by finding market data for pricing of similar property or services between unrelated parties.
In the case of our client, after studying the related-party transactions, I normalized the financial statements to arrive at market-based controlling interest cash flows, to determine equity values on an operating basis. Once values were determined for each enterprise, I adjusted to the level of value of our client’s minority interests using appropriate discounts for lack of control and marketability.
Related party transactions exist in many family-owned and closely-held businesses,and their affect on value needs to be considered and handled according to the intended use and circumstances of the valuation. Feel free to call us if we can provide additional information or help with a current business valuation need.
Pro’s and Con’s of Price Formulas in Buy-Sell Agreements
- Relatively quick and easy to calculate
- Inexpensive to apply
Upcoming Event: A Fast-Paced Overview of Business Valuation for Attorneys
Tip for Maximizing Business Value: Build for the Future
Why Should I Bother Valuing My Business?
Factors to Consider When Valuing a Closely Held Company
Revenue Ruling 59-60 was developed by the Internal Revenue Service to provide guidelines for the valuation of closely held companies. The ruling specifically addresses stock valuations for gift and estate tax purposes, yet the principles set forth are commonly applied in a wide spectrum of business valuations, including those prepared for employee stock ownership plans, charitable contributions, shareholder buy-sell agreements, mergers and acquisition transactions, SBA loans, corporate reorganizations, marital dissolutions and bankruptcies.
Revenue Ruling 59-60 suggests analyzing eight significant factors. They are:
1. Nature of the business and the history of the enterprise from its inception.
A value analyst assesses the basic business model, major milestones, growth, management, diversity of operations, and more, in order to understand the company’s stability, future prospects and risks.
2. Economic outlook in general and the condition of the specific industry in particular.
Economic conditions at the global, national, state and local levels, are considered, as appropriate for the business being valued. The industry in which the company operates is analyzed to understand its maturity, volatility, systematic risks, competitiveness and future prospects, and the company’s position within the industry is studied.
3. Book value of the stock and the financial condition of the business.
Balance sheets for the past 3-5 years are generally reviewed for financial condition and trends. The value analyst looks at liquidity, working capital, investment in fixed assets, long-term indebtedness, capital structure and so forth. When more than one class of stock exists, voting rights, dividend preference, and rights upon liquidation are considered.
4. Earning capacity of the company.
Income statements for the past several years are examined to determine levels and trends in revenues, cost of goods and operating expenses. Accounting irregularities are often ‘normalized’ and nonrecurring and extraordinary income and expense adjustments are made. When valuing a controlling interest in a company, owner compensation and perquisites are adjusted to market rates. The goal is to understand true earnings capacity from the perspective of a willing buyer. When available, management’s financial projections are analyzed as well.
5. Dividend-paying capacity.
The value analyst considers, in addition to the earnings of a company, the amount available to pay in the form of dividends to the owners after allowing for the cash and capital needs of the company. A company’s ability to pay dividends may show no relationship to past dividends paid, since dividend policy is set by controlling shareholders.
6. Whether or not the enterprise has goodwill or other intangible value.
Goodwill generally arises from a going concern company’s intangible assets and is primarily evidenced by a company’s ability to generate earnings. Brand, reputation, patents, trade secrets, institutionalized knowledge, customer relationships and simple longevity in the market may contribute to intangible value. Intangible value is a significant portion of the total value of most operating companies today.
7. Sales of the stock and the size of the block of the stock to be valued.
Previous sales of shares in the company should be reviewed to determine whether they represent prior arms-length transactions. Whether the block of shares being valued is a controlling or non-controlling interest affects value. For many reasons, the values of two different blocks of stock may not be the same.
8. Market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
The price of actively traded stocks of similar companies is primarily used to appraise large closely held companies. It involves identifying small public companies that are in the same industry and using the stock prices of those companies with some other financial metric (earnings, cash flow, book value, etc.) to determine price multiples that can be applied to the company being valued. To use this method properly, a comparable (or guideline) public company must be similar and relevant to be used as a surrogate for the subject company. As industry author Gary Trugman likes to say, “Comparing the local hardware store with Home Depot may involve similar businesses, but let’s face it, where’s the relevance?”
Click here to download IRS Revenue Ruling 59-60 in its entirety.
For business valuation experts, Revenue Ruling 59-60 is akin to the Bible. Okay I exaggerate, but not by much! It is definitely the most-cited reference source in the business valuation reports that we have been asked to review over the years.
Exit Strategies values private companies for business owners before they make important decisions about sales, mergers acquisitions, recapitalizations, buy-sell agreements, equity incentive plans, and more. If you are business owner and would like to learn more or discuss a potential M&A transaction or valuation need, confidentially, give Al Statz a call at 707-781-8580.