Will appear on BV pages – RECENT VALUATION ARTICLES

Why Should I get My Business Valued?

I received a call the other day from a friend who owns a publishing company. I was telling him about the types of valuation projects I was working on, and he asked, “I’m not in the middle of selling my business or transferring it to my children; why would I want to have my business valued? Besides, I know the rules of thumb for my industry.” The answer I gave him was essentially the following.
First of all, I said, most owners have heard several rules of thumb, but those rules of thumb are usually superficial, ambiguous, full of exceptions or just plain wrong.
Like most owners, my friend didn’t know if the rules indicated a value of equity, total invested capital, only certain assets, or something else.  As in this case, there are often several rules of thumb floating around—and they can’t all be right! Few business owners are confident that they understand the value of their business. And the price expectation of those who are confident is possibly too low…more often too high. In either case, it makes sense to get those expectations right, right?
Second, I said, the stakes are too high not to know the value of your business.
For most owners of small to medium-sized businesses like my friend’s, their business represents a substantial part of their net worth. Furthermore, proceeds from a business sale are often the planned source of some or all of their retirement funds. What if your expected selling price isn’t realistic or achievable? Conversely, what if you’ve already met your target value, would you sell now? You receive a statement every month from your stock brokerage telling you the value of your securities investments, right? Why wouldn’t you want to know the true value of your business at least every year or two?
Third, I told him, wouldn’t you like to improve the value of your business?
Wouldn’t it be wonderful to have a seasoned independent expert pinpoint the drivers and detractors of value in your business today? We encourage company owners who are planning to exit in the next five years to get a confidential assessment done now. This provides the business owner with a probable selling price (a number or range) and a solid basis for making sound decisions about exit strategy and improving the value of the business. Our assessments actually go well beyond value and look at marketability, finance-ability, transferrability, due diligence survivability, and other factors that are important to a successful exit. We often spot issues that are legal, tax and financial in nature and direct our clients to competent advisers in those areas. Then, after owners make adjustments in their business, we can measure progress periodically (every year or two) by updating the assessment, and give additional recommendations for reaching the next level when appropriate.
Sooner or later, everyone exits their business. The question is, do you want to leave it to chance? Or do you want to maximize value, preserve wealth, minimize risk, and exit on your terms?
J. Roy Martinez is a Certified Valuation Analyst (CVA) and business broker/M&A adviser. He can be reached at jroymartinez@exitstrategiesgroup.com or 707-778-2040.

Increase Business Value with Agreements

I recently completed an exit planning valuation of a business that enjoyed a very favorable discount on purchases of a key component used in the assembly of its products. The discount, negotiated many years ago, was a handshake deal between the founder of the company and his former employer who manufactured the component.  This large discount enables the business to be significantly more profitable that it would be otherwise.  Any investor or buyer for this business will naturally be concerned about whether the company can continue buying this component at the same below-market price.
We advised the business owner that before putting the business on the market, he try to secure a long-term contract with the vendor at the favorable discount, or attempt to find an alternate supplier of a comparable component at a similar price.  If successful, his business will have substantially higher value and will attract more potential buyers when he goes to market.
Agreements, properly structured, can increase enterprise value by reducing risk for buyers and shareholders.
Agreements to Have in Place Before Selling a Business
  • 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
As part of an exit plan, business owners should examine all of their company’s third-party agreements, whether written or verbal, for things such as clarity, economic terms at market or better, contract term, exclusivity, transferability, legal validity and more. Involve competent legal counsel in all but the most routine business arrangements.
 
For advice on selling your company, preparing it to sell, or understanding its value and transfer-ability, call Jim Leonhard at 916-800-2716 or Email jhleonhard@exitstrategiesgroup.com. 

Tip for Maximizing Business Value: Diversify Your Customer Base

16__272x300_Our seller and business valuation clients are usually proud of their company’s long-term relationships with major clients, and with good reason. Having a high percentage of business with a few customers can be a very profitable and personally satisfying way to run a business. It allows management to focus its attention and fine tune company operations to deliver exceptional service in a very cost-efficient manner. Customer acquisition expenses (marketing, sales, estimating, etc.) can be greatly curtailed or eliminated. It’s wonderful while it lasts.
 
So, what’s the problem?
When it comes to selling a company, owners need to know that customer concentration is a major problem. Most buyers won’t purchase a business with a highly-concentrated customer base.  Or, given two potential business acquisitions that offer the same expected return on investment, they will buy the less risky one. They will acquire the riskier business only if compensated by higher expected returns; in other words, by paying a lower price.
In general, when a business goes through an ownership or management change, it becomes more susceptible to losing clients. Also, since financial leverage is used in most business acquisitions, the effect of a major client loss on cash flow is more severe for buyers than sellers. Losing a top client can be an inconvenience for shareholders under the seller’s watch, and catastrophic to a buyer.
What can cause a key customer stop buying? 
  1. They get lower pricing from a domestic or foreign competitor.
  2. They bring production of your product or service in house.
  3. Their parent company shuts down the division that you’ve been supplying, or relocates it outside of your service area.
  4. They acquire one of your competitors, who becomes their preferred supplier.
  5. Or, they are acquired, and the parent has another preferred supplier.
  6. Your key contact person retires; new management doesn’t have the same loyalties and may prefer another supplier.
  7. Products run their course; the next generation product will no longer use the component you’ve been supplying all these years.
  8. The company changes strategic direction and no longer needs your products or services.
  9. Any number of other business motives and external circumstances beyond your control!
Strategies to mitigate customer concentration risk
Develop a deep understanding of your key client’s business risks. Take a close look at their financial condition if you can, and closely watch your payment terms to them. Understand their product life cycles and how that affects your company. Also, if you are the primary contact person, introduce one of your sales staff to the client so that future sales are not dependent on your personal relationship.
Another strategy to partially mitigate concentration risk is to negotiate a long-term supply agreement with dominant customers (an suppliers).  A supply agreement commits your customer to buying and you to selling your product or service on specified terms and conditions for a certain period of time. Putting a long-term supply agreement in place can be an interim measure while you develop a longer-term diversification strategy.
The most obvious strategy to reduce customer concentration risk is to expand your customer base. Embark on a sales and marketing program to get more customers. A good rule of thumb is that no one customer should represent more than 10% of your annual sales.
Business owners looking to maximize value in a sale must find a way to diversify their customer base!
Customer concentration is just one of many factors that drive value in a business. Feel free to call us if we can provide additional information or help with your exit strategy. Al Statz can be reached at 707-778-2040 or alstatz@exitstrategiesgroup.com. 

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

Exit Strategies is regularly called upon to determine the value of closely-held company shares for buy-sell transactions. Common events that trigger a transfer of shares are when a shareholder retires or resigns from employment, is fired, dies, or becomes disabled, divorced or insolvent.
There are several facets to successful buy-sell transactions, but valuation is typically the most contested issue. The pricing method prescribed in your by-laws, shareholder, buy-sell or stock restriction agreement, as the case may be, is critical to the success of your next buy-sell transaction. Chances are your agreement (if you have one) stipulates one of these pricing approaches: a) a fixed price, b) book value, c) a formula, or d) an independent business valuation by one or more appraisers.
This article discusses the pro’s and con’s of formula pricing versus an independent valuation. Fixed price and book value are almost always bad ideas, so I won’t bother with them. Valuation formulas in the Buy-Sell agreements brought to us are usually pretty simple and look something like this:
Equity Value  =  Average EBITDA in the past two years  X  a fixed Multiple
Pro’s of a Pricing Formulapick_any_two
  1. Relatively quick and easy to calculate
  2. Inexpensive to apply
If your priority is to get to a price quickly with minimum effort and expense, congratulations, job done.
Con’s of a Pricing Formula
If however you and your partners’ want to see that all participants receive and pay a fair price, a set pricing formula misses the mark more often than not. One of the basic problems is that transactions occur sometime in the future, not when the formula is fixed, and formulas become stale as business and market conditions change over time.
Also, valuation itself is a forward-looking concept, and formulas generally use historical financial metrics. In other words, an investor ultimately cares only about what his or her return will be going forward, not what it was or would have been in the past. History is important in business valuation, but should never be entirely relied upon in determining the value of a company. As experienced business appraisers we see many companies whose future prospects are significantly better or worse than their recent past performance.
Let’s go into detail on some of the problems and solutions.
Businesses change.  A static formula can’t anticipate a change in business model.  One real-life example is a company that began life as a project-based, low margin contractor/installer of security systems, and evolved over time into a monitoring company with hundreds of annual customer contracts and high margins. Since monitoring companies trade for higher multiples than construction companies, the agreed-upon valuation formula undervalued the company when one of the owners died.  Solution: Rewrite the buy-sell agreement to require an independent valuation when a trigger event occurs.
Market conditions change.  Future market conditions are unknowable, and impossible to design into a formula. Consider the example of a real medium-size photographic processing company. With the advent of digital cameras and smart phone cameras, its film processing business was in steady decline when the founding partner wanted to retire. The pricing formula, which had been set 10 years earlier, overvalued the shares at the time of the trigger event. This led to a falling out and put a heavy burden on the remaining shareholders.  Solution: Require an independent valuation, or periodically update the formula at a minimum.
Stuff happens.  Major non-recurring events that substantially alter a company’s performance can happen at any time (think major lawsuit settlement, windfall sale, plant relocation or expansion, etc.). When such events occur during the formula’s measurement period, one side or the other gets penalized. Another issue we’ve seen many times, particularly as company owners age, is that they begin to rely on fewer and fewer major customers or suppliers for most of their business, which represents a major risk factor that won’t be accounted for in a pricing formula. For many reasons, pricing formulas can be rendered obsolete when things happen.  Solution: Have an expert evaluate the entire company at the time of the transaction.
Incomplete formula.  Most valuation formulas presented to us are too simplistic. What if, for example, the above formula was used to value an asset-intensive business — let’s say a heavy construction company. If the company had been deferring capital expenditures for several years, the formula would overvalue the company. Likewise, if it had recently replaced most of its equipment, possibly to take advantage of tax incentives, the formula would likely undervalue the company.  A formula can never be comprehensive and robust enough to capture all of the unique factors that can impact a company’s value.  I could list several dozen examples of this.  Solution: Have a seasoned appraiser thoroughly evaluate the company at the time of the transaction. If you must use a formula, have a qualified business appraiser design and update it periodically.
Formula is unclear or unfair.  Some of the pricing formulas presented to us are ambiguous in one or more significant ways; others are just plain unfair to one side or the other.  Usually the owners are completely unaware of this until a real trigger event occurs, at which point they are no longer objective. Sometimes the CPA or attorney who created the formula years ago is out of the picture or doesn’t remember what they intended.  Solution: Again, an independent valuation is the best option. Having a qualified business appraiser design and update the formula is second best. At a minimum, have your existing formula reviewed by a qualified business appraiser who can spot these types of problems and recommend improvements.
In summary, a pricing formula usually yields a share price that fails to reflect true economic value at the time of transfer; which leaves at least one party very unhappy. This is why most buy-sell agreements call for a business valuation. If you must use a formula, have it designed and reviewed periodically by a professional business appraiser for the reasons discussed here. If you have business partners and don’t have a buy-sell agreement in place, I urge you to create one now, before you are faced with a trigger event.
Business valuation plays a pivotal role in internal share transfers and all business succession plans. If I can provide additional information or advice on a current situation, please don’t hesitate to call me, Al Statz, 707-778-2040 or Email alstatz@exitstrategiesgroup.com. 

Upcoming Event: A Fast-Paced Overview of Business Valuation for Attorneys

On January 29, 2014, Al Statz of Exit Strategies will be speaking to the Sonoma County Bar Association in Santa Rosa, California.
The workshop, titled A Fast-Paced Overview of Business Valuation for Attorneys”, will rapidly cover a wide range of valuation topics that will help attorney’s spot important issues and use business valuations more effectively in their practices. The comments will address valuations in estate, gift and tax, shareholder disputes, CC§2000 cases, marital dissolution, and of course M&A transactions.
This presentation is open to the public. Click here for more information and to register.

Tip for Maximizing Business Value: Build for the Future

Is your business built for the future?
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Consumer behaviors, markets, regulations and technology are changing so fast these days that many business owners are having trouble keeping up.  And if the business doesn’t have a strong future, it simply won’t trade at a high valuation, or many not have any value at all.
Private business owners must constantly monitor changes in their industry and marketplace, and make appropriate investments and take appropriate steps to insure the long-term relevance, growth and value of their company when they are ready to sell.
Read the Forbes article, “Leadership Matters – Comparing Ballmer to Bezos and Lessons You Should Learn”.

Why Should I Bother Valuing My Business?

ForbesA new article at Forbes.com addresses a question in the minds of many small business owners, “Why Should I Bother Valuing My Business?” 
The author explains several of the common reasons small business owners have their businesses appraised by an independent business valuation expert, as they prepare for a sale, buy-out, contingencies, retirement, or passing the business on to children.

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.

Importance of a Proper Valuation before Offering a Business for Sale

Lately I’ve been spending a lot of time working on an acquisition search for a client, and in this process I found many business offerings that were priced far too high and several that were under-priced. From a buyer and seller perspective, overpricing is a massive waste of time. At the other extreme, when price is set too low, seller’s leave hard-earned money on the table. Both situations can easily be avoided by obtaining a proper business valuation before going to market.
Business valuation is an integrated process of research, historic financial review, normalization adjustments, trend analysis, financial ratio assessment, economic and industry conditions and outlook, and detailed company-specific SWOT analysis. Studying the internal strengths and weaknesses of a business, how it compares to its industry peers, and having a detailed understanding of external conditions helps the appraiser properly apply the market and income approaches to value. Relying on financial analysis alone is like trying to climb a mountain face without a rope. You might make it to the top, or it could end in catastrophe!
For example, look at the printing industry. Years ago, large expensive printing presses were needed to produce the end product. Capital equipment investment was huge. With the introduction of digital printing and digital media, the opposite is true. If one were valuing a printing company back in the 1990’s and didn’t consider the industry outlook, the value conclusion would have been unrealistic. Another example is when a few customers represent a high percentage of a company’s revenues. The financials may support a higher valuation, but the risk is high and value will be heavily discounted. Banks usually turn down such loans.
Even when an exceptionally high price for a business has been agreed upon, the probability of a successful closing diminishes because of the financing component. Without third-party financing, the number of business sales transactions getting done would be lower, average percentage cash to sellers at the closing table would be less, and average purchase prices would be lower. Financing cannot be ignored.
As I discussed in a previous Blog (Reducing Cost of Capital in a Small Business Acquisition, posted Aug 27, 2013), most SBA loans, the primary source of institutional debt financing for small business acquisitions (up to $5,000,000 transaction size), require a business appraisal by a certified appraiser. In such cases, if the agreed upon price is higher than the appraiser’s conclusion of value, the lender will typically loan on the appraised value only. The price of the business has to be reduced, the buyer must come up with more cash (without borrowing it somewhere else), or the seller must finance the excess, without receiving payment for several years.
Market participants should also be aware that lenders and appraisers have to adhere to certain standards when an SBA loan is involved. For example, lenders will not accept certain income statement adjustments, such as state income tax paid by California S-Corporations (most buyers will likely want to form their own S-Corp), health insurance premiums (most buyers will also want to pay this out of the business cash flow), and excessive personal expense adjustments. Also, any representation of cash flows that are not reported on the books is not allowed, for obvious reasons.
Lastly, please remember the Principle of Substitution, which states that “the value of a thing tends to be set by the cost of an equally desirable substitute,” and the fact that buyers have choices in an active market, pricing a business properly is a critical first step toward a successful sale.
Pricing your life’s work at its intrinsic value to you, relying on rules of thumb, or basing it on a broker or accountant’s back-of-the-envelope calculations is usually either a waste of your time or a big financial mistake. When there’s so much at stake, do it right the first time and having your business properly appraised by an expert. It’s just good business.
Thanks for reading, and please let us know when you’re ready to properly price your business. — Bob