Tip for Maximizing Business Value: Build for the Future

Is your business built for the future?
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

IRS Requires Qualified Appraisals from Qualified Appraisers

Taxpayers should be aware and tax practitioners must know that Internal Revenue Service regulations for filing of estate and gift tax returns and charitable contributions involving business interests worth more than $5,000 require a qualified (business) appraisal by a qualified (business) appraiser. How do our friends at the IRS define these terms you ask? Please read on …
The IRS defines a qualified appraisal as an appraisal report that:
  1. is made, signed and dated by a qualified appraiser in accordance with generally accepted appraisal standards;
  2. meets the relevant requirements of IRC Regulations section 1.170A-13(c)(3) and Notice 2006-96, 2006-46 I.R.B. 902 (available at www.irs.gov/irb/2006-46_IRB/ar13.html);
  3. relates to an appraisal made not earlier than 60 days before the date of contribution of the appraised property;
  4. does not involve a prohibited appraisal fee; and
  5. includes specific information, such as a property description, terms of the sale agreement, appraiser identification information, date of valuation and valuation methods employed, among other requirements.
And the IRS defines a qualified appraiser as an individual who:
  1. Has earned an appraisal designation from a recognized professional appraisal organization (such as the ASA, NACVA, IBA, etc.) or has met certain minimum education and experience requirements
  2. Regularly prepares appraisals for which the individual is paid
  3. Demonstrates verifiable education and experience in valuing the type of property being appraised
  4. Has not been prohibited from practicing before the IRS under section 330(c) of Title 31 of the United States Code at any time during the three-year period ending on the date of the appraisal
  5. Is not an excluded individual (someone who is the donor or recipient of the property).
The IRS is serious about the quality and reliability of appraisals submitted with tax returns. Tax practitioners need to pay attention to the credentials and experience of the appraisers they select and understand the type appraisal reports that they obtain. When you need a business appraisal for a tax filing, our appraisers would be happy to discuss the appropriate scope of valuation analysis and report for your particular needs.

Engagement Review: Valuation for Partnership Dispute

Recently, Exit Strategies was engaged to perform a business valuation to resolve a dispute between partners in an Environmental Consulting Firm.
Facts and Circumstances
There were four equal partners (LLC members in this case). The firm’s business model had evolved over the years in response to changing market conditions, and the owners’ objective was to have one of the partners leave the firm and have the remaining partners acquire the equity of the departing partner. The company did not have a written buy-sell agreement that defined valuation in the event of a buyout. The parties were at an impasse as to the value of the 25% interest. Tensions were high and business performance was beginning to suffer.
The Result
Exit Strategies was called in by the company’s law firm to perform an independent business valuation for the buy-sell. We were asked to determine the fair market value of the subject interest and present our conclusion to the partners in an objective, clear and convincing manner. We were retained by the company and we asked all shareholders to sign our engagement letter.
With our valuation in hand, which clearly laid out the data, assumptions, material factors, approaches, methods and calculations that led to our conclusion of value, the feuding partners were able to quickly resolve their differences, culminating in an agreement between the parties and an amicable buyout.
Lessons Learned
Exit Strategies regularly performs valuations for Buy-Sell transactions between equity holders, using an appropriate level of due diligence, analysis and reporting that gives shareholders the information and confidence they need to make decisions.
Shareholder buyouts (and buy-ins) periodically occur in privately held companies involving multiple shareholders. In our experience, for buy-sell transactions to be successful, all shareholders, whether departing, remaining or incoming, must believe that they are being treated fairly.
Regardless of whether or not a Buy-Sell Agreement exists, a well-documented professional business valuation as of the transaction date is a major step toward keeping personal bias and emotions in check, and enabling the equity holders to reach an amicable agreement. In most instances, valuation is the most important element, and the sooner it is addressed the better for all concerned.
A third party valuation often serves as a great foundation to facilitate an agreement. With a professional business valuation in hand, shareholders are not only more likely to negotiate successful transactions, but also avoid costly, distracting and time consuming disputes that harm the business and personal relationships.
Exit Strategies Group, Inc. conducts business valuations for a variety of purposes including negotiating a sale, securing financing, settling a legal dispute, gift and estate tax, divorce, and shareholder buy-sell to name a few. For more information or to discuss an immediate need, you can reach J. Roy Martinez at 707-778-2040 or jroymartinez@exitstrategiesgroup.com.

Role of Business Appraisers and M&A Advisors in Estates and Trusts

I was recently asked about Exit Strategies’ role as business appraisers and M&A advisors in estates, estate planning and trust administration.  Here was my answer …

Business Valuation (a.k.a. Appraisal)

As business valuation experts, we provide fair market value appraisals of closely-held corporations, FLPs and LLCs for estate planning, gifting, estate tax, charitable donations, buy-sell transactions and succession planning. We value fractional interests in operating companies and asset holding companies using appropriate discounts. Our appraisers adhere to recognized professional standards, perform appropriate due diligence and meet or exceed accepted reporting requirements. And of course we are prepared to defend our work in the unlikely event of an IRS challenge.

For estates containing closely held business interests, we determine value of the decedent’s interest. We can provide input to the attorney on the effect of using the alternative valuation date.

With regard to trust administration, when a privately held business interest is placed in trust, our business valuation can help the fiduciary establish a baseline value and enhance their understanding of the asset. An independent business valuation can also avoid any potential for conflict of interest, since fees charged by trustees are often based upon the value of the assets managed. Subsequent valuations may be ordered by the fiduciary to assess the investment’s performance over time.

In estate planning where a family business is one of the owner’s major assets, a business valuation is often the starting point for estate planning professionals as they consider various estate planning techniques. Valuations provide a basis for the owner to evaluate potential ownership transfers and gifts; and can safeguard against future IRS challenges.

Landscape photo by Lance Kuehne

Landscape photo by Lance Kuehne

When drafting entity agreement and buy-sell agreement terms, attorneys have to balance flexibility and efficiency of operations with restricting control and marketability. During this stage, we can identify problem valuation situations or problem assets and identify the effects of gift and estate planning alternatives on valuation. We can also provide feedback and input on operating agreement terms that impact value.

When business owners gift ownership in their businesses, we determine value as of the date of gift. When closely held business interests are donated to a Charitable Remainder Trust (CRT), our business valuation can support the charitable deduction by the donor taxpayer.

Sometimes estate planning involves business succession planning. Like estate planning, real business succession planning is emotionally charged and often meets with resistance from clients.  A business valuation provides an objective look at many aspects of a business, including its management, marketability, inherent risks, and future prospects. The very act of going through the valuation process with an experienced and independent appraiser sometimes provides the catalyst that owners and their families need to fully engage in succession and wealth transfer planning.

M&A Advisors (a.k.a. business brokers, investment bankers, intermediaries, etc.)

There are many instances in which a generational transfer of a family-owned business is not the best option for a family. Often the children aren’t qualified to run the company or simply aren’t interested. Or the industry may be consolidating and an opportunity exists to sell the business for far more than fair market value and create substantial wealth and liquidity for the family.

Here, our firm regularly advises owners in the positioning, document preparation, strategic marketing and confidential selling process. We lead the M&A sale process for the client and work alongside their tax and legal advisors to maximize proceeds and preserve wealth.

Business valuations and M&A brokerage play a part in many estate and trust matters and succession planning for family owned businesses. For additional information or for advice on a current need, you can call Exit Strategies’ founder and president Al Statz at 707-781-8580. 

Goodwill Part II: Goodwill vs. Goodwill Value

All businesses have goodwill; however, not all businesses have goodwill value!

Goodwill, which is usually the largest portion of the purchase price of a business, is the sum of intangibles such as having a good location and trade dress, a negotiated lease in place, trained employees, a website, customers, etc. Not all businesses have goodwill value, which is measured by the amount of earnings the business produces adjusted for the risk of earnings continuing to flow into the future, since all value is in anticipation of future economic benefit.

IRS Revenue Ruling 68-6091  defines this very well. The Ruling states that goodwill value is that component of the earnings stream that is in excess of a reasonable rate of return on the investment made in the Tangible Assets (furniture, fixtures, equipment and vehicles) that the business owns, AND after paying the owner a reasonable market wage for his/her services in the business. The latter is often referred to as a “return on labor,” which has nothing to do with the value of the business since a prospective buyer can get a management job in the same industry and obtain a market rate of compensation without investing a dime in a business opportunity. If there are earnings in excess of these two requirements it must be attributable to goodwill value.

[1] During prohibition, this was the formula designed by our government to fairly compensate owners of spirit, wine, or beer producers before closing them down. It might be the only good thing that came out of prohibition!

Goodwill Part I: Personal versus Enterprise Goodwill

Goodwill can exist in two different forms: Personal Goodwill, which is defined as an intangible asset that is attached to a person; and enterprise Goodwill, also an intangible asset that is attached to the business enterprise.

If goodwill is attached to an individual, it is non-severable since the person to which it is attached is not being sold. This also implies that the asset is non-transferrable. Of course brokers often make contractual arrangements between the parties to lessen the non-transferrable portion of personal goodwill to some degree depending on the nature of the business being transferred. Smaller businesses tend to have some amount of the personal goodwill component due to the owner’s personal contact with customers, or channel partners, or special chef in a restaurant operation, etc.

Similarly, with enterprise goodwill being attached to the enterprise, this asset is indeed transferrable because it is a part of the business being sold. So it may be obvious that enterprise goodwill usually transfers to the buyer without special arrangements. Personal goodwill, on the other hand, requires much deeper analysis to determine how, and how much of this intangible asset is reasonably transferrable to a willing buyer.

Without proper analysis of goodwill value, whether or not it is related to an individual (usually the owner), and thoughtful strategies for the transfer of the personal goodwill component, the value of a business can be significantly distorted (diminished).

Independent Valuation Litigation Support

This week I was asked to value a medical practice, relating to a dispute between shareholders. Before I head off to my secret fishing spot for the weekend, I want to share these thoughts about how independent valuation experts assist in the litigation or dispute resolution process.

Business valuation and transaction professionals are frequently engaged as independent financial experts for purposes of assisting in dispute resolution, litigation, or potential litigation. Litigation support services include any professional assistance provided to a client in a matter involving pending or potential litigation or dispute resolution proceedings before a trier of fact.

In rendering litigation support services, the expert may be retained to provide an expert opinion on the financial effects of facts and assumptions. In addition to forming an expert opinion, the expert may value a business, project future financial results, analyze the performance of a business operation, interpret financial data, opine on an impaired streamof earnings, or render other similar types of professional services.

In providing litigation-support services, an independent financial expert may play a role as:

  1. Expert. One who is qualified by knowledge, skill, experience, training, or education in performing business valuation services and/or related financial analyses.
  2. Expert Witness. An expert who is engaged to explain technical, scientific, or specialized knowledge in order to assist the trier of fact in understanding evidence.
  3. Arbitrator. An expert who serves as a trier of fact in an alternative dispute resolution context.
  4. Court-Appointed Expert. An expert who is engaged by a court to assist the trier of fact.
  5. Consulting or Advisory Expert. An expert who is engaged to review another expert’s work product or who is engaged to advise the client, lawyer or another expert witness about technical matters relating to the subject litigation, but who will not be called to testify at trial, and may or may not be independent. Accordingly, this Procedural Guideline may not apply to such an expert.

Source: ASA Business Valuation Standards, ©2009 American Society of Appraisers