Archive for the 'Business Valuation Tips' Category

Sooner or later, this questions pops up for most business people. Whether you are selling or buying a business, hand the reins to a younger generation, seek investment to grow the company, or need to fend off legal challenges, the issue of business value comes up.

Most business people have no clue about business valuation

Now if you are like the typical business person, you are busy running the company. Measuring what it is worth is not the sort of thing you do regularly. The same holds true for most business professional advisors, including CPAs and lawyers. Business valuation is a specialized area that calls for know-how and attention to detail.

Just like with any business chore, cutting corners does not pay dividends. You can ask your business partners for advice, but odds are they know little. Opinions and anecdotal suggestions are no help, most are misleading and overly simplistic. The devil, as the saying goes, is in the details.

How to value a business – a high stakes game

Trouble is, business valuation is about as important a decision making point as it gets. Just consider the amounts of money at stake. Mishandling business valuation is likely to cost you thousands, result in a failed business transaction or a court judgment you will hate. Ask a seasoned business broker and your will hear an uncomfortable statistic: nine out of ten private business sales fall through because the buyer and the seller do not agree on the business value and its selling price.

Courts and tax man use business appraisals aggressively

It gets even more troublesome if you face a legal challenge or questions from the tax man. Courts have a way of enforcing their point of view and you may find a court appointed business appraiser does not agree with your idea of business value. Unfortunately, such business valuations are binding on all parties and professional business appraisers are trusted by courts and tax authorities.

Approach business valuation with respect

Whenever professionals are needed for a business task, you can surmise it is not easy. Indeed, business valuation has a lot of moving parts. For one thing, there are three fundamental ways to value a business. No one way, or approach to valuing a business, is definitive. Put another way, there are several ways to look at what a business is worth. Each approach offers a different perspective. Business appraisers are a detail oriented lot, leaving no stone unturned in their quest for measuring business value.

How to value a business? Three ways to do it

The three ways are formally known as the asset, income, and market approaches. Investing in a business requires capital to acquire business assets. The cost of creating a successful company is considerable. The asset approach seeks to reveal business value based on its operating assets and liabilities.

On the other hand, you can view any business as an income producing entity. Making money at an acceptable level of risk is the key objective and this is the view taken by the income approach to business valuation.

In the real world, businesses operate in a competitive environment. Similar companies can be compared to see what they are worth. Such comparisons are the cornerstone of the market approach.

If you take a look at a professional business valuation, all three approaches are used to figure out what a business is worth. In conclusion, business appraisers like to tie all their findings together in stating the business value. It could be an average of all the calculated values, or a range.

Troubled by business value result? Check the assumptions

One reason business valuations cost good money is that business appraisers are expected to study reams of business information in order to make careful assumptions and express their educated opinion at the end of the report provided to the clients. Such assumptions drive the conclusions of business value. If you have trouble buying the number, go back and review the assumptions.

What? Does the value of business goodwill change depending on the amount of current liabilities carried by the company?

It may not sound intuitive, but it actually is true. Consider the well known capitalized excess earnings business valuation method, the go to technique when valuing business goodwill.

A trick question: how much capital is committed to the business operations?

If you take a close look at how this method works, you will notice that the net asset value is calculated as the difference between the adjusted business assets less its current liabilities. This net asset value is then multiplied by the fair rate of return to estimate the capital charge, or the amount due on the committed business capital. The greater the net asset value, the higher the capital charge.

Excess earnings – what’s left after return on committed capital

Now for the fun part. The capital charge is next subtracted from the business earnings basis in order to calculate the excess earnings. This quantity gives the method its name. The idea is that a well run business generates earnings in excess of the capital charge thus providing superior return on investment.

Higher excess earnings indicate higher business goodwill

The capitalized excess earnings method determines the value of business goodwill by capitalizing these excess earnings. So the higher the excess earnings, the greater the business goodwill value. Businesses that put more money into the owners’ pockets are associated with higher business goodwill.

Notice that the capital charge is affected by both the total business asset values as well as the current liabilities. Given the asset values, higher current liabilities result in a lower net asset value and smaller capital charge. This in turn leads to higher excess earnings and increases the amount of business goodwill.

That’s how the capitalized excess earnings valuation method works. But what does it tell you in pure economic terms?

Higher earnings with less capital required often result in higher business goodwill

It essentially implies that those businesses able to operate on lower net asset bases have higher goodwill. These companies use Other People’s Money very effectively to finance their operations, usually in the form of short term borrowing from their suppliers.

The secret behind e-commerce success – lower working capital requirements

An example would be an e-commerce online retailer that gets paid shortly after selling the products. At the same time, the company enjoys attractive short term financing terms from its vendors. In addition, it reduces the need for working capital by managing its inventory just in time. The result is lower inventory shrinkage, more economic reordering strategy, and less capital tied up to meet the sales goals.

This is one reason online businesses are often able to out-compete their brick-and-mortar competitors. The online companies do not require expensive real estate for merchandizing and can manage their inventory and other direct selling costs more flexibly. Online businesses tend to focus on efficient and cost effective order fulfillment without the extra overhead of a retail store presence in a high priced shopping mall.

One of the well established business valuation methods, the capitalized excess earnings technique has a long and storied history. The method is described by the United States IRS in its Revenue Ruling 68-609. Unfortunately, the ruling does not specify what it means by the net tangible asset value, a key input into this valuation method.

The business appraisal profession has not formed consensus on the preferred way of estimating the net tangible asset value. Instead, there are several commonly used alternatives:

  1. Gross business assets net of accumulated depreciation, also known as the net current value.
  2. Net current value of the financial and tangible assets less current liabilities.
  3. Net current value of tangible assets minus all liabilities.

Most business appraisers adopt the second definition when valuing a business by the capitalized excess earnings method. This is not to say that the other definitions are less acceptable.

What’s more, the definition you use is not all that important to the results you get with this valuation method. The end result is always the indication of value the business owners hold and as such it should not be affected by the particular definition of the asset value.

How can this be the case? Remember that the capitalized excess earnings method uses two rates of return: the fair rate of return on the net tangible assets and the capitalization rate used in calculating business goodwill. Depending on your choice of measuring the net tangible assets, these two rates of return can vary.

The important part of applying this valuation method correctly is not to dwell excessively on what comprises the asset values. The key is consistency across all choices you make in your calculations.

In other words, the measure of net tangible assets should be consistent with:

  • The choice of the fair rate of return.
  • The selection of the excess earnings cap rate.

Make sure your choices match, and the method will provide a supportable estimate of business value, including its goodwill.

Take a look at a typical professional business appraisal report. You will see that a number of valuation methods are used to establish business value. In fact, all business appraisal standards, e.g. USPAP and AICPA SSVS No 1, require that you use all three approaches whenever possible. If you do not, you need to explain why your valuation has omitted one or more approaches from consideration.

A sensible business person can ask: what is the best method to use in business appraisal? Often, the market comparables offer the most supportable evidence of business value. However, the question is how comparable your subject company is to other, similar businesses? Apples and oranges comparisons do happen.

The asset approach is very helpful as long as no significant technological or economic changes have been at play in the market. In addition, business assets should be easy to evaluate as to their physical condition and residual value. Let’s say the equipment or software the business uses have been leapfrogged by new advances in technology. Old machinery or out of date software applications may not be worth much in such cases, so applying the asset approach methods could lead to erroneous valuations.

The income approach methods let you put on an investor’s hat. The biggest challenge is the need to forecast the future financial results for the business. No one has the crystal ball, and your valuation using such methods as the discounted cash flow is only as good as your earnings projections. The assumptions you make drive the results.

Regardless of the valuation methods you choose, business appraisal is an expression of opinion. If your valuation engenders trust, your readers are likely to rely on the answers. When in doubt, consider a second opinion. A different pair of eyes may offer a different view of the business and what creates business value.

One of the key choices you need to make in your business valuation is the length of the financial forecasts. Some experts go as far as to project the business financials over 10 years into the future. In other words, the appraiser takes a leap of faith in order to predict the business earnings, expenses, financial condition, as well the discount and capitalization rates over the next decade.

Crystal ball, anyone?

Ask yourself, what was going on in the financial markets 10 years ago? Yep, the world stood at the door of one of the greatest risks in the market’s recent history. Remember the Great Recession of 2008 that almost sank the markets? It took years to recover from that devastating blow, and in many ways the markets have never been the same.

You have to be a believer to accept that anyone can reliably predict the events that have major impact on the economy, political situation, world events, and technology evolution over a decade. Ask average business people about the crystal ball needed to make such a prediction with any degree of accuracy. Hear them chuckle.

Market risk estimates – discount and cap rates

Financial forecasts also go hand in hand with long-term estimates of the discount and cap rates. Let’s say you put a stake in the ground and claim that the market risks would hold steady over the next 10 years so you can calculate a constant discount rate, say 20% per year.

This constant discount rate is based on the constant estimates of risk-free returns and equity risk premium that go into the Build-Up cost of capital calculation. Unfortunately, the real world experience shows us that constant rates of return simply do not exist. S&P 500 index returns vary over time, just take a look at the last decade’s numbers.

Forecasting business earnings without considering such global phenomena is error prone. Even the best managed companies are subject to the vagaries of the market as a whole. Most businesses have good years and bad when it comes to earnings. Ask the seasoned managers why? They often can’t explain either.

A straight-line linear regression forecast of earnings and expenses is a reasonable model as long as most of the historic conditions for the company continue to hold true in the future. Should this assumption prove false, your ‘business as usual’ financial model falls apart.

The risks we cannot anticipate are all the more likely, the longer the financial projection horizon. If your forecast is way off, the business valuation result will likely be misleading or downright false.

The takeaway is that shorter forecasts are most likely to be a better basis on which to build your business appraisal. The shorter the forecast, the more likely you are to hit the target. Calculating the results on the assumptions that don’t stray from reality is the best way to come up with a realistic business appraisal.

If you look at business appraisals whose results differ significantly, the most common reason is the different assumptions. Consider, for example, the discounted cash flow valuation. If a lower discount rate is chosen by the appraiser, the resulting business value may be understated. On the other hand, an unreasonably low discount rate would lead to a surprisingly high valuation.

When the results are surprising, it is a good idea to explain in the business valuation report how you have selected your discount and capitalization rates. Standard methodologies, such as the Build-Up or CAPM cost of capital models, are widely accepted and easily checked.

When in doubt, consider running several valuation scenarios, each with a different set of assumptions. The results produced cover a range of reasonable business values and may well help dispel skepticism.

When valuation is uncertain: Best case, Worst case, Most likely case scenarios

The same goes for the forecasts of earnings. If you feel a single forecast is likely to be challenged, create several scenarios with different earnings projections. It is common in such cases to use the best case, worst case, and most likely case forecasts. You can use each to calculate the business value result and report them in your conclusions.

This makes sense if you think about it. Business prospects are uncertain, and each may be associated with a different earnings outcome or business risk. While it is not practical to create hundreds of business appraisals, you can reduce the complexity by considering the range of outcomes that are likely to occur. The resulting business value would most likely fall somewhere in between.

Reporting your business valuation: single-point or range of values

Newer business valuation standards, such as the AICPA SSVS No 1, support reporting your business valuation as a range. Doing so may help you convey the idea that a single-point business value is not the best estimate for the subject business. It would be better to state that the value may vary depending on the actual business performance going forward.

Assumptions drive business value conclusion

When looking at two business appraisals that disagree, carefully review the assumptions used in each. Both reports should identify the same key value drivers and risks and provide the rationale for their importance in business valuation. As you read the two reports, you should be able to conclude as to which set of assumptions is more reasonable.

Time and again business people ask: which business valuation method is the best? The answer is, it depends.

If the business operates in a market niche where many similar companies sell, the market approach methods are a good choice. You can easily support your business value conclusions by pointing to a number of recent business sales as supporting evidence.

The downside is that no two companies are the same. A closer look may reveal that your business is unique in some respects making market comparisons misleading.

The asset approach to valuing a company is very supportable as long as the industry is not going through a rapid technological or economic change and the underlying business assets can be evaluated for their physical condition and marketability.

The downside is that the investors may not be currently interested in investing in these types of business assets. If the market is sluggish, the asset approach to valuing a company may look somewhat contrived.

The income approach to business valuation gives you the tools that are preferred by professional investors. Using such methods as the discounted cash flow technique, you focus on the fundamentals of the business itself that define its risk profile and earning power. This combination of risk and return is at the hart of business value measurement.

The difficulty is in creating accurate forecasts of future business earnings. No one has a crystal ball, and future events may not play out the way you like. Your business valuation results are no better than your assumptions.

In the end, business valuation is a statement of opinion. If you trust your judgment or that of your business appraiser, all is well. If you doubt the conclusions, ask for a second opinion.

If you are happy with the business valuation result, and can defend it convincingly to others, you probably have the right answer.

If you ever valued a private company, financial statements normalization or adjustment requirement should sound familiar. This key step is needed in order to reveal the true earning power of the company, the essential element underlying its economic value.

Put differently, misstating the financial condition of a business is a major error in business appraisal. Underestimate business earnings, and the business value is likely to come way under the true figure. Overestimate it, and your business valuation would look overly optimistic.

Financial statements prepared for public companies tend to be far more consistent as they must be filed with the US Securities and Exchange Commission, or SEC for short.

Consistent financial reporting is needed to help individual investors make informed decisions. The set of rules is known as the Generally Accepted Accounting Principles, or GAAP. While you won’t find a single place to go to review the GAAP rules, the accounting profession has developed a good handle on what GAAP means and how to implement it. Financial Accounting Standards Board (FASB) promulgates the actual rules.

The foundation of GAAP is the historical cost. This is important as only the business assets actually paid for are recorded on the company’s books. Your CPA can then trace any asset to its original purchase invoice. It is an elegant system that works flawlessly for tangible business assets such as property, land, machinery, furniture and fixtures. Taking stock of your business assets is straightforward – just trace their purchase, then chase the asset to its current place of use. If you can find it, you can inspect its current condition and add it to the asset tally.

This system works given two assumptions. First, the company’s assets are physical or tangible objects. Second, the asset values do not change rapidly over time. This works great in many traditional manufacturing and distribution industries. However, things are not as smooth when it comes to modern high tech businesses, especially software development companies.

Not to mention that many business software applications today are distributed or outsourced. How do you go about estimating the market value of software in a typical business?

Original purchase cost? What about the countless all-nighters your IT gurus had to pull in order to customize the software to its current working condition? Is the deployed application worth anything today or due for a major upgrade that costs thousands? An auditor’s worst nightmare, to be sure.

Clearly then, GAAP was conceived in the good old days before the age of the Web, software, and intangible assets such as copyrights and trademarks. Intellectual property assets, especially internally developed trade secrets, technology, and procedures, do not have a historical cost tied to the original purchase.

Today’s interpretation of GAAP demands that companies expense all investments made in developing and maintaining valuable intellectual property. Under GAAP, you can capitalize the cost of developing business software, not its true fair market value.

This real gap in GAAP is one reason business valuation methods such as the asset accumulation technique exist. To determine the business value, you compile the list of all business assets, tangible and intangible, costed, or internally developed, along with all the liabilities. The difference is the business value.

Take a look at a professional quality business appraisal, and you will notice that business value analysis is done three ways. These are called business valuation approaches: asset, income, and market.

In addition, you will spot a number of methods each valuation approach offers. Business appraisers include a number of such methods into their business value analysis.

You would hope that the results of all these valuation methods would come close. They usually do, but the numbers are not identical. Some differences are to be expected, but if one or two of the methods produce results that are way out of line with the rest, you should view it as a red flag. An error in business valuation is often lurking somewhere in the details.

While it is permissible to report business values as a range of numbers, most business people still prefer to see a single value. You can see in our business valuation report sample how the results of several methods are reconciled to produce a single opinion of business value.

You might say that a well considered conclusion of business value is why an appraiser gets paid the big bucks. Valuations that are well supported and carefully thought through should fall within a close value range of each other. A rule of thumb in the industry is that most business appraisers would come to within 10% of each other.

That 10% is still enough to encourage some business people to push for a result at one or the other end of the range. In this regard the overly aggressive clients should be admonished against getting carried away. If you push the appraiser to come up with a number and it gets challenged by an adverse party such as the tax authority or the court, you may be looking at a failed business valuation that loses all credibility.

The key business valuation standard, USPAP (Uniform Standards of Professional Appraisal Practice) states that appraisers must be independent of their client and the business being appraised. Your appraiser cannot have any financial interest in your company and try to benefit himself or herself by coming up with a specific figure.

Think about it, would you or your partners trust a business valuation prepared by the appraiser who also happens to own part of the company? There is a major incentive to overstate the value and reap the benefits of selling such a business at an inflated price. Truly, caveat emptor!

USPAP standard requires that the business appraiser disclose any interest in the company being valued. If the appraiser fails to do so, it would be seen as a serious violation as the business valuation report readers are not made aware of a potential bias.

Unsurprisingly, the ethical standards under the USPAP preclude any such interest on the part of the business appraiser. When preparing a business valuation for a client, you should clearly state in your report if any such interest or other concerns that could influence your conclusion exist.

Another tricky element to watch out for is contingent compensation of an appraiser. The question here is: does the business appraiser get paid for the time spent on the engagement? Or is there an additional compensation incentive based on the business value conclusion? While many other professional advisors take on projects on a contingency fee basis, this is unacceptable for business valuations.

The reason is the objectivity required of business appraisals. While a lawyer is expected to act as the client’s advocate, business appraiser must stick to the facts and come up with an unbiased opinion of business value. In other words, your business valuation should not be influenced ahead of time to achieve a specific outcome.

Unlike a business broker, the appraiser cannot be paid based on the success of the deal. If it was the case, no reasonable business person would believe the business appraisal. The whole premise of coming up with a credible estimation of what a business is worth would go right out the window.

Business people need to know if they can rely upon business valuation in making strategic decisions such as buying or selling a company, approaching a lender or talking with the tax authorities.

Business appraisers must earn credibility. This rules out a sales pitch or a biased opinion aimed to deceive. Used car sales tactics may work well at a dealership, but have no place in professional business appraisals.

If you consult the USPAP Standard, you will notice that the appraiser’s fees must be based solely on the time spent on the engagement. Contingent payments or compensation based on the business value result are strictly prohibited.