If you need to determine the value of goodwill of a business or professional practice, the capitalized excess earnings method is an excellent tool. This asset-based valuation method, known as the Treasury method, is especially well suited for goodwill estimation for all types of privately owned companies.

Treasury method uses two rates of return

One important element of this technique is the use of two rates of return in the calculations. One is the so-called fair return on net tangible assets. The other is the capitalization rate used to calculate the value of goodwill from the business excess earnings.

Improper selection of these two rates is perhaps the most common source of errors in business valuation using this method. So it behooves you to choose these values with care.

Choosing the rates of return for your business valuation

Since the excess earnings method looks at the sum total of tangible business assets, it makes sense to use the firm’s discount rate as the fair rate of return.

The idea is that the business owners, acting as investors in their own company, expect the return on the committed capital to be commensurable with the overall business risk. That is exactly what the company’s discount rate captures.

The discount and capitalization rates are related. In fact the cap rate is just the difference between the discount rate and the firm’s expected long-term earnings growth rate.

This being the case, it is reasonable again to use the overall business capitalization rate when calculating the value of your firm’s business goodwill. The Treasury method accomplishes this by capitalizing the excess earnings.

Business goodwill needs to be a finite number

One final note on your business goodwill result. It is common practice to assume that the excess earnings can be capitalized over a finite number of years. So the cap rate should be limited to a number that does not drop below a certain threshold. The typical limits are 3 to 10 years. For example, setting the 10 year limit will give you the cap rate of 10% or greater.

If you are valuing a private business for any reason, the market approach should be an essential part of your analysis. There are a couple of methods you can use to establish the value of a privately owned firm:

• Comparative transaction method
• Guideline public company method

To use the comparative transaction method you basically develop a set of valuation multiples by observing the recent sales of private businesses that are similar to yours. These companies should be involved in the same market sector, be about the same in size, and show similar financial and operational attributes to the firm being valued.

The main challenge with using the comparative transaction method is gathering enough reliable data on such comparable business sales. Here are the main problems you are likely to face:

• Private business sale data reporting is not required by law, many deals go completely unreported.
• Business financials for private firms are not subject to financial reporting standards such as GAAP. This affects the reliability of your valuation multiples.
• When debt financing is hard to come by the deal flow for private business acquisitions slows down. So there are fewer recent transactions to compare against. This has certainly been the case in the recent economic environment as investors shied away from doing more risky deals.
• The reported data are not subject to review by independent financial accounting entities. This is quite unlike the reports on public companies.

In contrast, there is plenty of reliable data on business sale transactions involving publicly traded firms. These transactions are usually reported to government agencies, such as the Securities and Exchange Commission in the US. The filings are made along with the audited financials so the valuation multiples you get are pretty reliable.

However, the guideline public companies, even small ones, are usually far more marketable than their privately owned counterparts. This reduces the investor risk and makes business ownership interests more valuable.

Given this, what is the best practice you can adopt when using the market-based business valuation methods?

Combining the comparative transaction and guideline public company methods may be a good choice. You can gather enough data on private business acquisitions that you consider reliable. Where such data are insufficient or missing, consider using the guideline public companies that closely resemble your business.

This works quite well for the mid-market sector because many of such private firms are managed similar to the public companies. Once you have calculated the desired valuation multiples for your comparison, do not forget to adjust them for the lack of private company marketability using an appropriate DLOM (discount for lack of marketability).

Using this combined approach should give you enough tools to do a market based value comparison for just about any private business. As a rule, the market based valuation results are reported in the Low – Median – Average – High format.

Have you considered using the Discounted Cash Flow method in your business valuation? If so, much of the work is in creating reliable business earnings forecasts and assessing its risk.

An often overlooked part of the discounted cash flow method analysis is estimation of the long-term business earnings growth rate. This important factor affects the so-called terminal value of the business. It is the residual value of a going concern that is added on top of discounted cash flows when calculating the overall business value.

If you take a closer look at the terminal value formula, you will see that the business earnings growth rate appears in the denominator. In fact, this equals the business capitalization rate. Note that the cap rate is the difference between the company’s discount rate and earnings growth.

One common situation the business appraisers face is how to accurately estimate this earnings growth number. Should it be based in some way on your cash flows forecast? Or does the answer lie elsewhere?

A number of businesses, especially young companies, may experience periods of rapid earnings growth. If you base your long-term earnings growth estimate on this, you may come up with a number that exceeds the business discount rate.

Mathematically this produces a negative capitalization rate. In economic terms, this means that the business cost of capital is below its long-term earnings growth prospects, an impossible scenario.

The net result is that the terminal value becomes a negative number and the discounted cash flow analysis breaks down. What this tells us is that the long-term earnings growth rate has been overestimated.

In the short run, your business earnings may well grow rapidly. However, as the company matures a number of factors act to limit its growth prospects. New competitors enter the market exerting a downward pressure on the company’s profits. Market saturation demands that the firm look for additional income elsewhere. Products and services eventually need upgrading which calls for capital infusions further reducing the available cash flow from the business operations.

So where should you look for guidance in assessing the business long-term earnings growth? Consider a few possibilities:

• Look at the overall economic situation both regionally and nationally. Is your earnings growth expectation realistic against this background?
• Estimate the industry sector growth rates. Are your projections consistent with the industry peers’ performance?
• Carefully review your cash flow forecast. Do you anticipate some growth spurt to occur that should be followed by a period of more stable earnings?

Remember that the key reason the terminal value is added to the discounted cash flow valuation is that you may have trouble coming up with a reliable earnings forecast too far into the future.

This uncertainty would call for a conservative estimation of the business profitability going forward. And it usually means a sensible earnings growth estimate and a more defensible business valuation result.

A common reason business people need to have their business appraised is gift and estate tax situations. Business ownership grants by living owners to family members trigger a gift tax liability.

If an owner passes away, the business is inherited by other partners or family members. One rather unsavory chore they need to handle quickly is how to pay the very large estate taxes. The tax bite of up to 50% of the business value can be very painful.

Business valuation that holds up to scrutiny by the tax authorities

As a rule, business owners are interested in the highest possible business valuation result. This is certainly true when the company is offered for sale or an outside investment is sought, whether venture capital or debt financing. A partner buy-in is another situation that calls for the highest defensible business valuation.

Valuations for gift and estate taxes are quite different. Since the tax is levied on the current business enterprise value, business owners are interested in the lowest supportable valuation.

If your business valuation is too low, expect the tax authorities to be skeptical. Experienced tax agents are aware that business people want to reduce their taxes. Even if you retain skilled accountants and attorneys, a business valuation that is too low will likely draw the attention of the tax man.

If fact, the tax authorities may come up with their own valuation for your business. You will have to defend your appraisal if their number is considerably higher than yours.

Business valuation standard of value for gift and estate tax appraisals

Fair market value is the typical standard used to value businesses in these situations. The subtle difference you need to know about is that the definition of this standard may differ from that used in business acquisition scenarios.

Specifically, gift and estate tax valuations consider what the business is worth to a hypothetical business buyer without regard to special synergies that could result in a higher potential business selling price. If you plan to use the income based methods such as the Discounted Cash Flow, be aware that conservative earnings forecasts are usually acceptable as long as they are realistic.

Business valuation: points of contention

Business owners, their professional advisors and tax agents usually clash on these points:

• Total business enterprise value
• Discount for lack of control applied to a minority ownership stake
• Lack of marketability discount used in valuation

Since your business valuation result depends upon a set of assumptions made, tax agents can challenge you on your financial forecasts, business risk estimation, as well as the definition and premise of value used.

Business valuation is about the future outlook of earnings and risk. Will the business revenue continue to grow at the historic 5% a year? Will the industry sector become more risky over the next 5 years?

Will the business continue running as usual or need to exit some markets and drop some products? Will the business need to expend considerable resources to acquire new assets? Depending on the answers your valuation results may vary quite a bit.

Marketability discount and business sales comps

Tax agents usually understand that a private company is harder to sell than shares of stock in a publicly traded firm. The question is the amount of marketability discount applied when valuing a private business based on comparable business sales.

If you have a reliable source of comparable private business sales, you can offer very defensible evidence in support of your business valuation. The guideline public company method is another way to compare your business to similar small to mid-size public companies in the same industry.

Control premiums and minority discounts

This is another common bone of contention between business people and tax agents. An unreasonably high discount for lack of control reduces the value of the business ownership interest – and taxes due.

You can come up with defensible minority discounts by citing control premiums paid by public companies that acquire controlling stakes in other firms. Since public companies must disclose such transactions, you can review the control premiums and calculate a sensible minority discount from these data. Case law in your jurisdiction may shed additional light on what is usually acceptable in gift and estate tax valuations.

Are you preparing a valuation for a home remodeling contractor business? Here are some important industry stats to consider:

The home remodeling companies are usually classified within the specialty contractor industry sector under the SIC code 1799 and NAICS 236220. These businesses generate combined annual revenues of $41.96B. There are some 105,000 such firms in the US alone employing about 474,700 people.

Yet the average home remodeling company is a typical small business – with annual revenues of $400,000 and a staff of just 5.

Business valuation of home remodeling contractor companies

Established home remodeling contractors with a steady pipeline of projects often are profitable, highly desirable businesses. Such companies are sought after in acquisitions and the selling prices offer you an excellent way to estimate your own business value by comparison.

Valuation multiples calculated from these business sales comps are the valuation tools of choice under the market approach. The common valuation multiples used for home remodeling contractor valuations are:

• Business value to revenues (net sales)
• Business value to EBITDA
• Business value to hard assets such as Property, Plant and Equipment (PPE)
• Business value to total business assets
• Business value to owners’ equity

Example: Use of valuation multiples for valuation of home remodeling contractors

To illustrate the market-based valuation technique, let’s pick a typical home remodeling company with the following yearly financials:

• Revenue: $400,000
• EBITDA: $58,000
• Total business assets: $165,500

Now let’s apply a set of reasonable valuation multiples derived from comparable contractor firms that sold recently and calculate the business value for our sample company:

You can use the average value calculated from all the estimates above, or establish your company’s worth as a range of values, from the low to high estimate.

Quite a few privately owned businesses and professional practices have more than one co-owner partner. Unplanned departure of a partner can have a major effect on the success of a business going forward.

To safeguard business continuity, you as business owners need to plan ahead about how to transfer business ownership interests with minimal business interruption.

In addition, you should think about what the departing partner’s share is worth and the sources of funding for a partner buyout. In such situations, business valuation is a strategic management tool.

What buy-sell agreements do

As business partners you can address the need for such future ownership transfers by creating a formal buy-sell agreement. At a minimum, such an agreement should help you address these concerns:

• Specify which events may trigger the provisions in the buy-sell agreement. Examples are partner departure due to death, illness, divorce, retirement or major falling out.
• Provide a clear way of determining the value of the departing partner’s business ownership interest.
• Specify the sources of funds to pay for the partner buyout.
• Prevent the partner’s share of business from falling into the hands of an undesirable party.
• Word the buy-sell provisions in a way that will be honored by the legal and tax authorities.

How buy-sell agreements are structured

To start, your buy-sell agreement must establish the party that buys the departing owner’s share of business. There are several ways to handle this:

• Entity purchase, where the business buys back the ownership from the outgoing partner.
• Shareholder purchase, where the remaining owners buy the former partner’s interest.
• Wait and see agreement, where the decision as to who buys out the partner is deferred until the triggering event takes place.

Business valuation provision in a buy-sell agreement

How the partner ownership interest is valued is an important part of the agreement. The remaining co-owners must choose how and when the business appraisal is to be done. Your key decision points here are fairness to all the business owners, affordability, and tax considerations.

To be binding, your buy-sell agreement should clearly state the standard and premise of business value as well as the approaches and methods used to calculate the valuation results. The typical ways of structuring a valuation provision for your buy-sell agreement are these:

• A business value figure set by mutual agreement among the business owners. You should update this at least annually.
• A choice of business valuation methods that the co-owners have agreed to use to determine the business value.
• Requirement that a professional business appraiser be retained to conduct business valuation.

Valuation of the entire business is the first step. The next question is how to allocate this business enterprise value among the co-owners.

One option you may choose is to divide the total business value in proportion to the partners’ shares of ownership. Let’s say there are two partners who own an equal share of the business worth $1,000,000. In the pro-rata allocation scenario, each partner owns $500,000 or half of the entire business.

Control premia and minority discounts

If, on the other hand, one partner owns 75% of the business and the other the remaining 25%, the pro-rata allocation may not be the best choice. In this case the partner holding the 75% stake has the so-called controlling ownership interest. This may be more valuable because this co-owner enjoys a number of advantages over the minority partner:

• Decision as to the timing and size of dividend payouts or partner draws.
• Election of directors.
• Key hiring decisions.
• Acquisition and sale of business assets.
• Raising additional capital for business expansion.

The controlling owner’s business share may be worth more than 75% in this case. The difference is referred to as control premium. You can estimate what that premium is by observing the share prices paid by public companies seeking to acquire a controlling stake in other firms.

Once you know the control premium, you can determine the minority discount from it. This will give you the ratio to apply to the pro-rata share of ownership held by the partner with 25% of the business interest.

If you are valuing an established company, business goodwill may well be a substantial part of the overall business value. One of the central methods to estimate the value of business goodwill is the Capitalized Excess Earnings technique, also known as the Treasury Method.

Business people and financial advisers are sometimes confused by the results they get when estimating the value of business goodwill. Is it possible that goodwill is actually negative? Can business have an unexpectedly high value of business goodwill compared to its industry peers?

A closer look at the Capitalized Excess Earnings valuation method

To address these questions, take a closer look at how the Treasury Method works:

First, the method requires that you specify the current business earnings, usually as some measure of its cash flow. In addition, you need to provide the values of business assets and its current liabilities. Finally, you need to specify the fair rate of return on these business assets as well as the estimate of the earnings growth rate going forward.

The Treasury Method first calculates the so-called capital charge – the portion of the earnings that indicates the return on the business tangible assets. The capital charge is subtracted from your earnings input and what is left is called excess earnings.

It is the capitalized value of the business excess earnings that defines the amount of business goodwill being present.

Some business valuation results may be unexpected

Note that if the business asset base is unusually high, the capital charge may well equal or even exceed the current business earnings. As a result, there are no excess earnings and hence, no business goodwill – at least not in the economic sense.

Conversely, the fair rate of return, representing your business risk, may be high. Here again, the capital charge can quite large even for reasonable values of business assets. The result may well be business goodwill that is lower than you expected.

Ways to handle unusual values of business goodwill

If you run into these situations, here are some ideas to consider:

Carefully examine the values of business assets you include in your calculations. Are all these assets used to produce the business earnings? Uncommitted or overvalued business assets are one reason the Treasury Method may underestimate your business goodwill.

Take a closer look at the fair rate of return on these assets. Ensure that it truly represents the risk associated with the business operations that use the assets to produce the earnings.

Biotechnology companies comprise an important and growing industry, classified under SIC code 2836 and engaged in the research, development and marketing of diverse products for the health and biosciences industries.

There are 1,280 such establishments in the US alone generating about $24.2B in annual sales and employing just under 30,000. An average firm makes $22,900,000 in annual revenues with 25 staff.

Business valuation of biotech firms

Biotechnology companies may grow rapidly and achieve considerable profitability. As a result they are often the targets of acquisitions. Valuation methods based on the market of comparable business sales are quite common for valuation of businesses in this industry sector.

Valuation multiples are the typical tools under the market approach. They let you estimate the value of your firm based on the the enterprise values of comparable firms relative to their financial performance. The common valuation multiples used are:

• Enterprise value (EV) to revenues (net sales)
• EV to EBITDA
• EV to Property, Plant and Equipment (PPE) assets
• EV to total business assets
• EV to book value of owners’ equity

Example: Use of valuation multiples for biotech company value estimation

As an example, let’s pick an average biotechnology company with the following annual financials:

• Revenue: $22,900,000
• EBITDA: $800,000
• Total business assets: $1,800,000

Using the valuation multiples derived from comparable small cap firms we calculate the business value and summarize the results as follows:

The values may fall closer together or wider apart depending upon how well your specific biotech company matches the industry average across the various income and asset bases.

You may come across this situation when valuing a private business: the company owns substantial real estate assets in addition to business operations. By convention, businesses are appraised as though the premises were rented rather than owned. If the company owns its premises and does not pay rent to the landowners, you need to factor a fair market rental expense into its income statement.

Consider business and real property separately in your business valuation

This puts the company on an equal footing with its industry sector peers. Remember that business value is defined by business earnings. Since it is typical for companies to lease their premises, you need to consider the effect of this expense on the business cash flow and business valuation calculations, especially with such income-based methods as the Discounted Cash Flow.

What about the business owned real property? You should determine its market value separately, as though the property were put on the market to get the highest and best renter.

The net operating income (NOI) from this arrangement along with the capitalization rate define the economic value of the property. If the business were to be put on the market, along with its real estate holdings, the value of the package would be the sum of business and real estate values, considered separately.

Valuing a business and real estate together

One business valuation method that you can use for your calculations is the well-known Multiple of Discretionary Earnings technique. As you go through your valuation analysis, input the fair market value of the real property along with any other non-operating / excess business assets. The method then lets you calculate the valuation result than combines the business and real estate values.

When it comes to valuing a private business using market-based methods, one valuation multiple that stands out is the price to business revenues. Actually, there are two variants of this distinguished valuation tool:

• Price to gross revenue
• Price to net sales

In fact, there are a number of industry sectors where the price to sales valuation multiples are preferred. Here are the top ones:

• Professional practices, especially medical and dental practices
• Technology companies in high growth mode
• Manufacturing businesses, especially those in emerging market segments

With so many valuation multiples to choose from, why would business people and professional appraisers trust price to sales numbers more? Because in some situations this measure of business value is more reliable. Here are some scenarios when you may want to consider using the business revenues as the key basis to appraise a company:

Professional practice value is about client retention

Client retention is essential to preserve the value of a professional practice that is being sold. Essentially, the practice buyer is after the revenue stream of the practice and may have plans regarding profitability improvement or capital investments. Hence, the valuation multiples based on profits, say the practice net income or EBITDA, as less valuable when estimating what the practice is worth.

High growth company value depends on sales growth

Young growing companies can become very attractive if they manage to establish themselves as a leader in a market niche. Their ability to generate revenues in a highly promising industry sector is the major value driver. In this sense, the company’s revenue is a strong predictor of its success – that sheds light on how valuable the firm is.

At the same time, such companies may not yet have been optimized for top profitability. In addition, further business expansion may call for considerable capital investment. So, again, using valuation multiples based on profitability or current asset base is not as revealing.

Business value is driven by market share and revenue growth

The same argument holds for established manufacturing businesses that are successful in a new market sector. Imagine a company that has developed a strong customer following in one of the green industry segments.

Early entrants with a compelling product and service mix tend to grab market share and generate sales quickly. You can capture this key value driver by using the price to revenue valuation multiples when appraising such a company.

Income valuation methods to supplement your business appraisal

To round out your business valuation, do not forget to take advantage of other methods, especially those under the income approach. The Discounted Cash Flow method in particular is an excellent supplement to value a business based on earnings forecast and risk going forward.

Such expectation driven business appraisal is a powerful way to verify the business value estimates you get from the market-based valuation multiples.