Will appear on BV pages – RECENT VALUATION ARTICLES

The Importance of a Credible and Competent Valuation Expert

/in , /by Al Statz

Al StatzThe need for business valuation arises in many circumstances ranging from dispute resolution, to estate planning, to the sale of a business to name only a few.  As in all professional disciplines, it is important to hire a practitioner who is fully trained, able to discern relevant facts, and abreast of current best practices. Consider the following New York Supreme Court case.*

Adelstein v. Finest Food Distributing Co

Two brothers and their uncle each owned a one-third interest in a distribution business.  The brothers had offered to buy out the uncle. The uncle refused, the relationship deteriorated, and the case became a matter for the New York courts to decide.

The Brothers’ Expert

The expert for the brothers was a CPA lacking a business valuation credential, who had reportedly performed about 50 business valuations. His valuation report was three pages in length, based on a review of the company’s tax returns, and conversations with its accountant and its principals.  He chose an income approach, using the capitalized income method.  His rationale for using just one approach was that he couldn’t find comparable market transactions and that the company was not public. Normalizing adjustments produced an income stream of $206,000. A derived 20% capitalization rate was based upon company-specific risk factors such as customer concentration and limited management; applied a 20% discount for lack of marketability. He concluded the uncle’s one-third interest was worth $230,000.

The Uncle’s Expert

The uncle’s expert was a credentialed business appraiser.  His review included tax returns, general ledger, bank statements, and sales reports.  He found sales had doubled, gross margin declined, while officer compensation increased from $0 to $500,000. Further due diligence revealed 20% of sales were cash payments not recorded on the books. Analysis of sales reports found unrecorded sales of almost $1 million.  Additionally, he imputed industry gross margins of 35% versus 25% company reported margins.  The income approach produced a normalized income stream of $486,000, a 12% capitalization rate, a 5% discount, and a $4,050,000 value. As a sanity check, he applied a market approach using transaction data commonly accessed by professional business appraisers. In applying market multiples for sales, gross profit, and EBITDA he found a range of values between $3,990,000 and $4,191,000. He gave a 70% weight to the income derived value; 10% weight to each market derived value.  He concluded the uncle’s one-third interest was worth $1,287,000.

The Court’s Decision

The court affirmed the uncle’s expert citing his “credibility and reliability of valuation methods.”  Specifically, the court noted his qualifications, the use of more than one valuation method, and more objective and rigorous due diligence to support his conclusion.  Importantly, the uncle’s expert also demonstrated an understanding of state law on the applicability of minority discounts.

This case illustrates the wide range of business valuations and experts found out there in the real world.  More often than not, relying on a cursory review of an entity’s operations and a single method of valuation will omit key value determinants.

Accurate valuation requires an understanding of professional valuation standards and a rigorous analytical process that can be clearly explained and understood. Whatever the intended use of a business valuation, working with a trustworthy, experienced and accredited valuation professional usually provides the most accurate and defensible result.

* Adelstein v. Finest Food Distributing Co., 2014 N.Y. App. Div. LEXIS 2542 (April 16, 2014); Matter of Adelstein v. Finest Food Distributing Co., 2011 N.Y. LEXIS 5956 (Nov. 3, 2011)

Exit Strategies’ team of accredited business valuation experts have over 100 years of combined experience.  Please contact us for a frank, confidential discussion about a potential business valuation, sale, merger or valuation need.

Upcoming Event on Valuation of Ag and Food Businesses

/in , /by Al Statz

Al Statz of Exit Strategies Group will be a panelist for the American Society of Appraisers (ASA) Northern California workshop —Working with a Going Concern: Valuation Issues Related to Ag-Food Processing Facilities, on Saturday, May 31, 2014, in Fairfield, California.

A Message From Al:

My passion is helping baby boomer business owners exit right and retire well. My background as a valuation and M&A professional, business owner and corporate development executive allows me to bring a wealth of knowledge and real-world experience to help closely held and family business owners understand their options, maximize value and achieve successful ownership transfers.
 
I enjoy speaking to groups of business owners on these topics. I also regularly speak to advisers to business owners – accountants, attorneys, lenders, wealth management professionals and industry associations. With baby boomer retirements on the rise, these groups are increasingly looking for experts to educate their constituents. Well look no further! If you own a business or advise business owners and want to explore booking me to speak to your group, Email or call me at 707-778-2040. Thank you.

– See more at: https://webcache.googleusercontent.com/search?q=cache:HnnS5z8O5O4J:www.exitstrategiesgroup.com/blog.html%3Fbpid%3D3943+&cd=1&hl=en&ct=clnk&gl=us#sthash.FYoxOdVu.dpuf

Is it too early to have my business valued?

/in , /by Roy Martinez

A potential client has been dragging his feet on having a business valuation done. Most recently, he asked, “Is it too early to have my business valued?” A better question may be, is it too late?

This baby boomer wants to exit his business and retire in the next 2-5 years. He said, if the business isn’t worth much, he would probably hold on to it and transition management of the business to a group of employees over time. If the business is worth a lot, he would sell now and retire as soon as he had transitioned the business to the buyer. Inherent in that discussion is the fact that he really doesn’t know how much his business is worth.

As I pointed out in my blog post of February 26, 2014, “Why Should I Get My Business Valued”, for most business owners, their business in one of their biggest assets (often their biggest). Every month you know what your securities portfolio is worth. You can go to Zillow.com for an estimate of your home’s value. Similarly, you can go to Loop.net to get an idea of the value of your commercial real estate holdings. But where can you find the value of your biggest asset? The only ways are: 1) to market and sell your business or 2) to have your business valued by a qualified valuation expert.

My response to this business owner was:

“No, it is not too early. If you end up deciding to transition the business to your employees, it will take time. Doing it right can take 3-5 years or more. If you want to retire in 3-5 years, you already may be behind the game. And…if the business is worth enough for you to retire now, what are you waiting for?”

Most likely his business is worth somewhere between the two extremes that are occupying his mind. An accurate and well-documented business valuation will help him make better decisions with respect to managing the business and exiting in the right manner and in the appropriate time frame.

  1. 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.

What is Fair Market Value?

/in /by Al Statz
You’ve heard the term Fair Market Value many times. Fair Market Value is indeed the most common standard of value used in business valuations, but what does it actually mean?
Fair Market Value is typically defined as “the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both having reasonable knowledge of relevant facts.”  (Source: Treas. Regs. §20.2031-1(b) and §25.2512-1; and Rev. Rul. 59-60, 1959-1 C.B. 237)
You’ll see many slight variations on the Fair Market Value standard, but the above is the most broadly used and accepted definition.
Users of business valuations should be aware that the term Fair Market Value generally carries with it several basic assumptions that can have significant influence on the value analysis and concluded value:
  • Both the buyer and seller are hypothetical people
  • The buyer is at arms-length, able and willing to trade, prudent and seeking a fair return
  • Generally a financial buyer without benefits attributable to synergies
  • The business would be held on the market for a reasonable period
  • The business would sell for cash or equivalent
  • Both parties are well informed about the business and the market; the effect of business and financial risk, control and marketability characteristics on value; and the returns available from alternative investments.
Business owners, shareholders, attorneys, CPA’s and other users of valuations should also know that while Fair Market Value is applicable for many of the typical uses of business valuations, it isn’t always appropriate. Some other common standards of value in business valuation are listed in the following table:
Standard of Value Defined by:
Fair Value  (dissenting SH, minority oppression cases) Minority oppression statutes, California Corporations Code §2000.  Study case law to determine how interpreted.
Fair Value  (financial reporting) FASB, SEC.
Investment Value International Glossary of BV Terms.  When the buyer is known (not hypothetical).
Most Probable Selling Price International Business Brokers Association.
It is critical that the correct standard of value be used in your next business valuation.  For more information or help with a current business valuation need or exit strategy, contact Al Statz at 707-778-2040 or alstatz@exitstrategiesgroup.com.

Why Should I Only Retain a Certified Valuation Expert?

/in /by Jim Leonhard
If you’re thinking of using a non-certified or non-credentialed individual to value a business, consider the following recent judicial ruling.
The United States Tax Court ruled on February 11, 2014** that a valuation conducted by a non-valuation credentialed individual used for an estate tax filing was materially deficient.  The individual who prepared the valuation was both a CPA and a CFP (certified financial planner), had written 10-20 valuation reports, and had testified in court.  However, he lacked a business appraisal certification.
In brief, the court found that the estate had used an inappropriate valuation method (Capitalization of Dividends) versus the Commissioner’s expert (Net Asset Value) which led it to “substantially understate” the value of the estate as it was less than 65% of the Commissioner’s expert’s value.  As a result, the court found “that the estate has not demonstrated that it acted with reasonable cause and in good faith in reporting the value of the decedent’s interest in PHC on the estate tax return.” As a result, the Commissioner’s imposed an accuracy-related penalty in addition to the increased tax due.
The court stated that “in order to be able to invoke ‘reasonable cause’ in a case of this difficulty and magnitude, the estate needed to have the decedent’s interest in PHC appraised by a certified appraiser.  The estate relied on the valuation by [a non-certified appraiser], but did not show that he was really qualified to value the decedent’s interest in the company.” Furthermore, the court asserted that “we cannot say that the estate acted with reasonable cause and in good faith in using an unsigned draft report prepared by its accountant as its basis for reporting the value of the decedent’s interest … on the estate tax return.”  The Tax Court dismissed his valuation, determined that the estate owned an additional $2.8 million, plus a 20% accuracy-related penalty of over $1.1 million dollars.
** CLICK HERE for the details of the case: UNITED STATES TAX COURT, ESTATE OF HELEN P. RICHMOND, DECEASED, AMANDA ZERBEY, EXECUTRIX, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Docket No. 21448-09.
While this particular case involved an estate tax filing, most business valuations should be performed by a certified valuation professional to ensure accuracy and credibility.
For a certified business valuation or advice on exiting a company, please contact Jim Leonhard in the Sacramento, California area, 916-800-2716.

Why Should I get My Business Valued?

/in , /by Roy Martinez
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

/in , /by Jim Leonhard
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

/in , /by Al Statz
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

/in /by Jim Leonhard

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

/in , , /by Al Statz
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.