When a business sells, the owners are supposed to allocate the purchase price across all tangible and intangible assets. The overage is then deemed to be due to goodwill.
In the past, it mattered little if some of the important intangible assets were lumped together with business goodwill. The reason? There used to be little difference in how business intangible assets, such as intellectual property or customer contracts, were handled in the company’s financial records.
Business goodwill impairment
Along come the SFAS 141 an 142 published by the Financial Accounting Standards Board (FASB), and everything changes. No longer is business goodwill amortized. Rather, companies must conduct the goodwill impairment test and adjust their income statements accordingly. In addition, the Generally Accepted Accounting Principles (GAAP) now require that all intangible assets be amortized. In other words, such assets as software, technology, customer and vendor contracts, patents, copyrights and trademarks, all are expected to be gradually used up in business operations.
With these new financial reporting rules, companies have an incentive to put high values on goodwill and reduce the values of other intangible assets. The benefit of this strategy is that you can increase the reported earnings without any effect on the business cash flow. Earnings per share go up, so the company stock value increases.
According to the US Securities and Exchange Commission (SEC), there are several types of business intangible assets that must be valued:
- Customer related intangibles
- Creative intangibles
- Marketing oriented intangible assets
- Technology specific intangibles
- Contractual intangible assets
All these assets must be recognized as distinct from business goodwill. Contract specific assets do not need to be actually separable. However, all other intangible assets must be capable of being sold on their own.
This sounds a bit tricky. The plain English meaning is that an intangible asset must be either based on a legally enforceable right, such as a customer contract, or be sellable by itself, such as a license to use a patented invention.
To see the difference, imagine the problems with trying to transfer a trained and assembled workforce to another company. You are unlikely to have this valuable asset preserved intact, in contrast to the licensing of a trademark.
Take a look at a professional business appraisal report and you will see a discussion of the current trends in the industry and expectations going forward. No business operates in a vacuum and economic conditions, especially emerging trends in the industry sector, make a big difference to what a company is worth.
Think about a growing company in an expanding industry with great profit potential and few large competitors who could dominate the market. Compare this to a declining industry controlled by a handful of deep pocketed mega-firms and major regulatory hurdles looming on the horizon.
The effect of such industry trends often far outweighs the overall economic conditions as it has the most direct influence on the company’s ability to compete.
When valuing a business, you need to pay careful attention to the industry trends and analyze how the company plans to rise up to the challenge. This requires a careful review of management, key staff, financial strength of the firm, its product and service competitive position. Your valuation report should help the reader see how the company fits into its market and why it will continue to be successful.
This analysis underlies the assumptions you make when calculating business value. Regardless of the actual methods you use to come up with your business valuation conclusion, the results should be based on sound assessment of the company’s industry and its prospects going forward. Cranking out numbers that ask your reader to suspend disbelief will not cut it.
If you are looking to appraise a business, looking at market evidence to support your conclusions is very useful. After all, the market is the final arbiter of what a company is worth. Short of test driving the market by putting your company up for sale, looking up recent business selling prices is the next best thing.
So far, so good. But the answer you get is only as good as the data you are able to gather. The old adage of ‘garbage in, garbage out’ applies to business valuations as well.
You may be tempted to delve into data sources touted as treasure troves of valuable data by their vendors. Comparing your company to similar firms that actually sold recently could help you work up a set of valuation multiples to estimate your business market value.
The devil, as the saying goes, is in the details. High quality data on private companies is scarce. Aside from filing tax returns with the Federal and local government, private companies are not obligated to disclose their financial and operational data to anyone. In fact, most private business owners consider such data highly proprietary and confidential.
So where do the data resellers get their data from? Usually, private company sales data comes from participating business brokers. While some brokers may disclose the details of their transactions, most consider such data their competitive advantage, and keep it under lock and key. When business seller prospects look around for a broker to sell their business, those with the most knowledge of the market tend to attract future customers.
The result is that most private company sales never get published. If you consult a data source on private business sales, you are likely to see only a small fragment of the deals actually made.
Most business brokers are sales people. Many lack the financial reporting skills and may report data that obscures the actual financial picture of the company. There is no compliance requirement with financial reporting standards, such as the Generally Accepted Accounting Principles or GAAP, as is the case for public companies.
Private business owners are famous for their skill at creative accounting in order to minimize taxable income. That’s why business appraisers spend considerable time adjusting company financials before appraisal. Since data on private companies does not include detailed background information, it is very difficult to adjust reported financials to reconstruct a true picture of company’s financial performance.
The result is your valuation multiples can be quite misleading.
As the saying goes, if something looks too good to be true, it probably is. If you doubt the valuation multiples you get by crunching the numbers obtained from a data reseller, it’s time for a ‘second opinion’. The best way is to source data on small capitalization public companies in the same industry. These firms are subject to the rules that mandate consistent financial reporting and full disclosure of the company’s current situation and prospects.
To make an ‘apples to apples’ comparison to a private company, adjust the valuation multiples you get for lack of marketability. The factor, known as DLOM, accounts for the relative reduction in business value because a private company cannot sell its stock freely to the public.
Now you can compare your valuation multiples from both public and private sources.