Valuation Basics for Business Owners and Investors

Valuation Basics for Business Owners and Investors

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Whether you’re looking to buy a closely held business, or sell your business, attract investors, gift a portion to your family, or simply understand its worth, here are some basic tips for business owners and investors regarding valuation:

Understand Different Valuation Methods

Various methods exist for valuing a business, including the Market Approach (sales of comparable businesses), Income Approach (a projection of cash flow), and Asset-Based Approach (book value, or assets less liabilities, all stated at market value). While the business owner or investor should not have the same expertise as a credentialled business appraiser, they should understand these methods to see which are most appropriate for their business. Asset methods can produce varying results for a company that has a modest investment in long-term assets and long-term liabilities.  Service companies typically are not valued based on their balance sheet. Real estate holding companies often are. A market approach is often not appropriate in valuing a bespoke, small company.  And most small businesses are bespoke, small companies!  The gigantic public companies and their valuation multiples are way too large, much more diversified and serve a broader geographic market to be relevant.  Private transaction data of sales of similar small companies is frequently too limited to use. An income approach may be suitable.  Under this approach, earnings are normalized to remove nonrecurring transactions such as lawsuits and PPP loan forgiveness.  Owner’s compensation and rent paid to related companies are adjusted to market rates. The objective of this normalizing process is to present financial statements that reflect the results a buyer would see after they purchase the company. No one buys nonrecurring transactions, and no one pays more (or less) than market rates.

Financial Statements and Other Records

Are the financial statements accurate and up-to-date?  Potential buyers or investors will closely examine a company’s financials, including income statements, balance sheets, and cash flow statements. Maintain at least five years’ worth of financial records and support. Preferably, this is more than just tax returns. Growth trends should be highlighted. Some advisors recommend keeping a corporate book outlining not just your financial results but your sales and marketing approach and how you meet customer needs.  Presenting this to a potential buyer will put you well ahead of other opportunities they are reviewing.  You’re the seller that is prepared!

Market Trends and Industry Comparisons

Stay informed about market trends and industry benchmarks and adapt as appropriate. Understanding how a business compares to others in its industry can provide valuable insights into its valuation. A company that is poised to reap the benefit of current or upcoming disruptions in the industry (e.g., use of AI to improve efficiency, use of social media and SEO in marketing), is in a better position than a company that has not adapted.

Customer Base and Revenue Diversity

A diverse customer base and revenue streams can enhance a business’s valuation. Dependence on a single customer or a few key ones may be viewed negatively. Why?  What if the competitive landscape changes and several key customers leave? The Company’s cash flows would significantly decline.  The added risk of customer concentration is imputed in the valuation.  An investor demands to be compensated for the risk in the future cash flows related to customer concentration, for example. Revenue diversity is important.  If consumer preferences shift away from a company’s only product or service, the Company must scramble to diversify revenue. Cash flow would decline.  Investors demand to be compensated for this risk, too.

Intellectual Property (“IP”) and Assets

Identify and value IP, patents, trademarks, and other assets, and protect them. The contribution to the overall value of the business is measured by the incremental cash flow the IP brings to the business.  If the IP is not yet cash flow positive, projections should be used to model probable future earnings as a proxy for value.

Future Growth Prospects

Communicate the business’s growth potential. A solid business plan outlining future opportunities and expansion strategies can positively impact its valuation. Is the business poised for economic change (this can come from a variety of sources including increased manufacturing capacity, a new product line, a shift to online sales and/or remote offices)?  If so, modeling potential growth scenarios would be helpful in the valuation of the business.

Management Team

A competent and experienced management team (including a succession plan) is an asset.  Highlight the skills and expertise of the management team. If the Company operates with one key person – typically the founder- take some time to create a succession plan and train/hire accordingly before the company markets itself for sale.  A younger buyer often does not want to be a one-person team.

Legal and Compliance Issues

Address any legal or compliance issues proactively. Clear documentation and compliance with regulations can instill confidence in potential buyers or investors.

Engage Professionals

Consider hiring professional business valuators, accountants, or financial advisors. Their expertise can provide a more accurate and unbiased assessment of a business’s value. Remember that valuation is both an art and a science, and it often involves negotiation. It’s essential to approach the process with transparency and a realistic understanding of a business’s strengths and weaknesses.   Please feel free to reach out with any questions or comments.

Demystifying Business Valuation: Unveiling the Art and Science

Demystifying Business Valuation: Unveiling the Art and Science

Introduction

Business valuation is a crucial aspect of corporate finance, providing insights into the worth of a business. Whether you are a business owner, investor, or stakeholder, understanding the methods and factors influencing valuation is essential for informed decision-making.

The Importance of Business Valuation

  1.    Strategic Decision Making: Business valuation assists in strategic decision-making processes such as mergers and acquisitions, partnerships, and expansion plans.
  2.    Investor Confidence: Investors often rely on business valuation to assess the potential return on investment and overall financial health of a company.
  3.    Financial Reporting: Accurate business valuation is essential for financial reporting, influencing aspects like asset impairment tests and goodwill assessments.

Methods of Business Valuation

  1.    Income-Based Approaches
      • Discounted Cash Flow (DCF): Evaluating the present value of future cash flows.
      • Capitalization of Earnings: Assessing the business value based on its expected earnings.
  2.    Market-Based Approaches
      • Comparable Company Analysis (CCA): Comparing the target business with similar companies in the market.
      • Precedent Transactions: Analyzing the value based on historical transactions in the industry.
  3.    Asset-Based Approaches
      • Book Value: Assessing the value based on the company’s balance sheet.
      • Adjusted Net Asset Method: Considering the fair market value of assets and liabilities.

Key Factors Influencing Business Valuation

  1.    Financial Performance: Consistent and positive financial performance enhances the business’s perceived value.
  2.    Market Conditions: Economic trends, industry growth, and market conditions impact valuation.
  3.    Intellectual Property and Intangibles: The value of patents, trademarks, and brand recognition can significantly affect valuation.
  4.    Management and Team: Competent and experienced management can contribute to a higher valuation.
  5.    Risks and Challenges: Assessing potential risks and challenges is crucial in determining a realistic valuation.

Challenges in Business Valuation

  1.    Subjectivity: Valuation is not an exact science; it involves subjective judgments and assumptions.
  2.    Changing Dynamics: Market conditions and industry trends can change rapidly, affecting the accuracy of valuations.
  3.    Intangible Assets: Valuing intangible assets, such as brand value or customer relationships, can be challenging.

Conclusion

Business valuation is both an art and a science, requiring a comprehensive understanding of financial principles, industry dynamics, and market conditions. Stakeholders must approach valuation with a nuanced perspective, considering multiple methods and factors to derive a realistic and informed business value.

In the ever-evolving landscape of finance and commerce, mastering the intricacies of business valuation is indispensable for making sound investment and strategic decisions.

Will Two Valuations Have the Same Conclusion?

Will Two Valuations Have the Same Conclusion?

In an ideal world, different appraisers arrive at the same conclusion when valuing a company. If there were a magic calculator that produces the valuation, then this dream would come true.

Reality differs.

A valuation is called an opinion of value for a reason. Appraisers, in most instances, must by professional and regulatory standards be independent of the subject company, its owners and the person or entity that engages them. Being independent does not mean they will see a set of facts and circumstances like another appraiser.

You and a friend see the latest Quentin Tarantino movie. You love its idiosyncrasies; they find it confusing and uninteresting. Who is right? You both are. You interpret differently the same film.

In a valuation, there are several areas where such variations can occur. The simplest is in the discounting.

Put simply, a lack of control discount (or minority discount) attempts to measure the fact that a holder of a minority interest cannot influence the daily or strategic operations of a company. There are several databases which measure this discount which the appraiser can reference.

But the databases just provide the starting point.

The company and its owners may have operating agreements, buy sell agreements or other such documents (“Agreements”) that may mitigate or even increase this discount. Some of examples where an Agreement may influence the discount include approvals of a majority, supermajority or even unanimous agreement to take certain actions.  A minority owner may be on the Board.  The Agreement may restrict transfers of interests.

Appraisers will hold different views of what the ultimate lack of control discount reflecting these will be.

The lack of marketability discount attempts to measure the loss in value associated with the difficulty of selling a small business, regardless of the size of the interest. Time on market, professional fees to support the sale, and broker fees contribute to this discount. The data backing these factors is often dated and subject to appraiser interpretation.

These discounts can be substantial; a minor variance in discounting between two appraisers will have a major effect on the opinion of value.

In determining value, the appraiser looks at three approaches: the market approach, the income approach, and the asset approach.

Briefly, the market approach looks at transactions in similar companies in both the public and private sectors. The income approach examines the income and cash flow the company can yield. The asset approach looks at the adjusted balance sheet where the assets and liabilities are restated to fair market value.

All three approaches require appraiser judgment. With the market approach, not only can the selection of comparable companies differ, but the normalizing adjustments the appraiser makes to their reported results may not be the same.

With the income approach, the appraiser may rely on a projection or on historical results to determine income or cash flow. The market approach and the income approach both require normalizing adjustments to items including compensation to key players and rent paid to related parties. The magnitude of these adjustments can differ depending on the data sources the appraiser relies on.

Under the asset approach, value reflects the fair market value of the underlying assets and liabilities. With assets such as cash, determining market value is straightforward. With receivables and inventory, determining market value is simpler when there are audited financial statements. Most small businesses though do not have audited statements.

When valuing assets such as machinery and equipment, and land and buildings, the appraiser depends on outside professionals to determine asset value.  Two such professionals may have different opinions of value on the same asset.

Valuing liabilities can be a challenge and is subject to appraiser interpretation.

With all this, it’s not surprising valuations have different results that doesn’t mean either one is wrong!

Is Your Operating Plan Outdated?

Is Your Operating Plan Outdated?

Management completes the company’s annual plan and smiles. Click that Done checkbox! The plan is forgotten.

In today’s rapidly changing business environment, “set it and forget” is dangerous.

First, let’s replace the word “plan”.  We are working with forecasts: what we expect to happen.

Technology, how we work, consumer behavior, and the economy are all changing at a rapid rate.  To be as profitable as it can, your business must change to reflect these factors.  A rolling forecast will show you the benefits of reacting now instead of next year.  Well ahead of your competition!

Rolling Forecast

As a “living” forecast, rolling forecasts are reevaluated throughout the year, often quarterly.  Your forecast’s level of detail should be enough to make sense. Not every detail line item, simply the higher-level categories.

Let’s look at COVID as an example. Companies rolled out their annual forecast on January 1, excited about the upcoming year. They set it and promptly forgot it.

In a few short weeks, news of the virus hit.  Companies realized their static forecast wasn’t going to be achieved, through no fault of their own.

Clearly, this is a dramatic example.  External challenges do arise, though.  One-time predictions rarely pan out exactly. Rolling forecasts will adapt to these moving challenges and opportunities.

A rolling forecast can be used in what-if analysis, to show the success (or failure) of new marketing techniques, changes in production techniques, pricing strategies, and more.    What if we change our marketing to online only, what can happen to sales and profits?  What if we outsource this product component?

Unexpected opportunities and new challenges are always popping up. Be prepared!

The Dollars and Cents Cost of Not Gifting Assets Now

The Dollars and Cents Cost of Not Gifting Assets Now

You’re inundated with a deluge of articles and guidance emphasizing the urgency of transferring your assets out of your estate now. Your failure to do so might result in significant tax liabilities.

The U.S. government has introduced an unprecedented historical gift tax exemption, allowing individuals to gift assets up to $12.92 million individually or jointly with their spouse, totaling $25.84 million. This exemption amount increases annually in line with the Chained Consumer Price Index.

However, this exceptionally high exemption is set to expire in 2025, after which it will decrease to an estimated range of $6 million to $8 million, depending on factors such as inflation.

You’ve likely read this estate tax exemption is a point of contention between Democrats and Republicans.  Democrats aim to eliminate it, while Republicans seek to extend it. This perpetual political battle adds another layer of uncertainty.

What does all of this mean for you? It’s nearly impossible to provide an exact answer, so I’ve devised a hypothetical scenario to illustrate the potential impact.

Suppose your business is presently valued at $10 million, and your other assets (investments, residences, etc.) amount to around $2.5 million, with both appreciating by 5% annually. This example assumes you are married and have not utilized any of your lifetime exemption. The scenario calculates potential taxes at the later of your and your spouse’s date of passing. Current federal regulations allow for the tax-free transfer of assets between spouses. Estate taxes may apply if assets are bequeathed to children or other beneficiaries upon your demise.

Note that this example does not consider state estate taxes, because they vary widely. Some states do not acknowledge gifts, while others impose no estate taxes at all. Additionally, some states may not permit a spousal exemption, making it essential to consult your professional advisors for tailored guidance.

Let’s explore the potential tax consequences of this scenario. I’ve ended the projection in 2032 simply as a placeholder.  The longer you and your spouse live, the greater the potential estate tax liabilities. The tax rates utilized are current as of 2023 and are subject to change.

Gifting assets does not need to lead to a reduction in your income. Your professional advisor is best equipped to devise a plan that preserves your income while addressing these tax considerations.

A Funded Buy Sell Agreement – Is it a Land Mine or a Gold Mine?

A Funded Buy Sell Agreement – Is it a Land Mine or a Gold Mine?

Imagine you and your partner formed an electrical contracting company.  You, Operations Partner, handle operations, Marketing Partner handles marketing and admin. It’s a beautiful arrangement.  It has worked well for decades.

Their Attorney tells them “You need a funded buy sell agreement.  If one of you dies, how will the company move on?”

“Another legal document? Another fee? And life insurance premiums, too? All money we can invest in the business or pay to ourselves!,” you exclaim!

A big takeaway from COVID is the unexpected will happen and always at the worst time.  Avoiding the future is as impossible as living forever.  The future happens whether we are ready for it or not.

Marketing Partner tragically dies. Their spouse is distraught.  Operations Partner now has a new partner, Marketing Partner’s Spouse.  Spouse knows nothing about electrical contracting and has zero interest in being involved in the business.

Operations Partner now runs the business alone. S/he is fielding calls from the Marketing Spouse and Spouse’s professional representatives.  “Where is my money?  How can I live with no income? You must help me!”

A well-written life insurance funded buy sell agreement will lay out what happens when a partner passes. It avoids these difficult circumstances and can fund a buyout.

What is the smart solution to avoid stress and costs?

Invest in an insurance buy-sell agreement.

Please consult with your CPA and attorney to see the implications for you.