Valuation

“There are many reasons for valuing an entity, and those circumstances can lead to different outcomes…For instance, a business’s value for sale on a going-concern basis will differ from its value for liquidation purposes.  It similarly makes a difference if the valuation is for an orderly liquidation as opposed to a forced one.  For example, the value of a company for estate-tax purposes (fair market value) likely will differ from its value for a sale to a specific purchaser (investment or strategic value).  In some instances involving litigation, the courts or the law may dictate which standard of value to use.”

     Source: Journal of Accountancy , August 2003

Introduction

The two variables – EBIT and DCF numbers – are affected by not only the financial aspects of the business but also the non-financial aspects, which can be both objective and subjective.  For purposes of buying or selling a company, it is important for the seller to determine the floor price (the lowest acceptable price) and for the buyer to determine the walk-away price (the highest possible offer).  Valuing companies may be more of an art than a science, but there are three basic factors that buyers focus on when trying to establish a price for a target company.

1.  Quality of Eearnings

i.e., not a lot of “add-backs” or one-time events like the sale of real estate which does not reflect on the true earning power of the company’s operations.  It is not unusual for companies to have some non-recurring expenses every year, whether it is a new roof on the plant, a hefty lawsuit, write-down of inventory, etc.

2.  Sustainability of Earnings After the Acquisition. 

The key question a buyer often asks is whether he is acquiring a company at the apex of its business cycle or whether the earnings will continue to grow at the previous rate.

3.  Verification of Information

i.e., the concern for the buyer is whether the information is accurate, timely and relatively unbiased.  Has the company allowed for possible product returns or allowed for uncollectible receivables?  Is the seller above-board, or are there skeletons in the closet?

Measuring Earnings

When a seller talks about earnings, earnings really needs to be defined; e.g., EBIT or EBITDA; last year’s earnings or this year’s projected earnings; EBITDA – CAP X; restated without prerequisites but with add-backs, etc.

When a buyer is analyzing earnings, is it for one year, three years, interim earnings annualized, combination of reporting periods, projections, etc.?  What is the timeframe for measuring earnings and what is the trend of earnings?

Another concern in measuring earnings in the future is related to what changes might affect earnings, such as increase in rent, family members off the payroll, loss of key customers and/or vendors, etc.  Beware of companies that are locked into long-,term contracts in which they are unable to raise prices or companies in a commodity-type business in which there is unrealistic market pricing.

Key Considerations

The following questions are useful to understand the business and thereby value the company more prudently:

• What’s for sale?  What’s not for sale?  Does it include real estate?  Are some of the machines leased instead of owned?
• What assets are not earning money?  Should these assets be sold off?
• What is proprietary?  Formulations, patents, software, etc.
• What is their competitive advantage?  A certain niche, superior marketing or better manufacturing?
• What is the barrier of entry?  Capital, low labor, tight relationships?
• What about employment agreements / non-competes?  Has the seller failed to secure these agreements from key employees?
• How does one grow the business?  (Maybe it can’t be grown.)
• How much working capital does one need to run the business?
• What is the depth of management and how dependent is the business on the owner/manager?
• How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?

Conclusion

Much of the information above will influence the person’s perception of value. Valuation is often in the eyes of the beholder, whether the price is rational or not.

Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.

The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.

So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.

However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.

Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.

Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.

Is there pricing elasticity?
What’s proprietary?
What’s the company’s competitive advantage?
Status of employment agreements and non-competes?

Post-Acquisition:
Are there cost savings after purchase?
Are there significant capital expenditures pending?
Is there synergy with the seller?
Is it perceived the integration will go smoothly?
Are there substantial cross-selling possibilities?
Will the cultures blend?

The Financials: By training and education, many business appraisers emphasize the numbers. They will look at the past, current and future numbers. They will consider all the basic financial figures such as:
• growth rate
• return on investment
• gross profit percentage
• EBITDA percentage
• industry metrics
• debt to net worth
• book value

Fundamentals: Business appraisers should also consider the company’s history, its management, products, distribution, etc. The following should also be seriously considered: multi-products, different markets, wide distribution and the quality of management.

Value Drivers: These are important business elements that are most often ignored or completely overlooked by business appraisers.  However, they are very important to a potential buyer.
• product differentiation
• defensible position
• technology
• dominant market share
• well-known brand(s)
• cost advantage
• proprietary customer

This question can only be answered by addressing other related questions, specifically: Who’s asking and for what purpose?

From the perspective of the owner, prospective buyers, the IRS, lenders and divorce & bankruptcy courts, the value of a business for purposes of a sale, estate planning, orderly or forced liquidation, gifting, divorce, etc. can be vastly different.

Intrinsically tied to the various purposes of valuation are numerous definitions of “value.” Here are a few examples:

Investment Value – The value an acquirer places on a business based on a future return on investment determined by assessing past and current performance, future prospects, and other opportunities and risk factors involving the business.

Liquidation Value – The value derived from the sale of the assets of a business that is closed or expected to be closed following the sale.

Book Value – Book value is the difference between the total assets and total liabilities as accounted for on the company’s balance sheet.

Going Concern Value – Used to define the intangible value which may exist as a result of a business having such attributes as an established, trained and knowledgeable workforce, a loyal customer base, in-place operating systems, etc.

Fair Market Value
For the purpose of this article, the focus will be on transaction related valuations. Fair Market Value (“FMV”) is the most relevant definition of “value” and is of the most interest to business owners. The more knowledge business owners and prospective buyers have about the valuation process, the more likely they will come to an agreement on a purchase price.

FMV is the measure of value most used by business appraisers, as well as the Internal Revenue Service (IRS) and the courts. FMV is essentially defined as “the value for which a business would sell assuming the buyer is under no compulsion to buy and the seller is under no compulsion to sell, and both parties are aware of all of the relevant facts of the transaction.” IRS Revenue Rule 59-60 lists the following factors to consider in establishing estimates of FMV:

1. The nature and history of the business.
2. The general economic outlook and its relation to the specific industry of the business under review.
3. The earnings capacity of the business.
4. The financial condition of the business and the book value of the ownership interest.
5. The ability of the business to distribute earnings to owners.
6. Whether or not the business has goodwill and other intangible assets.
7. Previous sales of ownership interests in the business and the size of ownership interests to be valued.
8. The market price of ownership interests in similar businesses that are actively traded in a free and open market, either on an exchange or over-the-counter.

What is Goodwill?
An important element of value, when it exists, is goodwill. The IRS defines goodwill in its Revenue Rule 59-60, stating, “In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value. In some instances it may not be possible to make a separate appraisal of the tangible and intangible assets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value for the tangible assets exceeds the net book value of such assets.”

Valuation Approaches and Methods
Exploring valuation techniques requires an understanding of the tools available. Which tools are utilized depends in part on the purpose of the valuation and the circumstances of the subject company. Generally there are several approaches to valuing a business. Within these approaches, there are several different methods. Listed below are the three major approaches along with some examples of specific methods that fall under each category.

• Income Approach
Discounted Cash Flow Method
Single Period Capitalization of Earnings Method
• Market Approach
Comparable Publicly Traded Company Analysis
Comparable Merger & Acquisition Analysis
• Asset-Based Approach
Adjusted Net Asset Method
Excess Earnings Method

All of the above methods and approaches are frequently used in business valuations.

Normalizing the Financial Statements
Before the approaches and methods above can be applied, it is necessary to analyze and normalize both the income statement and balance sheet of the business for the current and past periods selected to form the basis of the valuation.

• Normalizing the Income Statement

Normalizing the Income Statement generally entails adding back to earnings certain personal expenses, non-recurring and non-cash items. Examples of these “add-backs” could include depreciation, amortization, auto, boat and airplane expenses, one-time extraordinary expenses and other excess expenses such as owner’s salaries and family member’s salaries that are above fair market value, travel and entertainment, bonuses, etc. Owners usually tend to be extremely liberal when normalizing the income statement in order to bolster earnings, which can artificially inflate valuation. Each item must be carefully analyzed and scrutinized to insure that the normalization process is credible.

• Normalizing the Balance Sheet

Normalizing the Balance Sheet includes adjustments that eliminate non-operating assets and other assets and liabilities that are not included in the proposed transaction, and therefore the valuation. The book value of the assets will be adjusted up or down to reflect their fair market value. Inter-company charges will also be eliminated. Inventory may be adjusted upward or downward based on prior accounting procedures and/or obsolescence. Accounts receivable may also require an adjustment based on an analysis of collectibility.

Relevant Terminology:

EBIT – An acronym for earnings before interest and taxes

EBITDA – An acronym for earnings before interest, taxes, depreciation and amortization.

Capitalization Rate – Any divisor that is used to convert income into value. This is generally expressed as a percentage.

Discount Rate – The rate of return that is used to convert any future monetary gain into present value.

(Note: when determining FMV, the earnings stream selected to be capitalized or discounted should be normalized.)

Summary
Even with all the terminology and definitions discussed above, the answer to the original question has not yet completely been answered: What is the company worth?

The value driver of a business is the ability of the entity to generate future cash flow or earnings. Business appraisers will assign an appropriate capitalization rate (or multiple) to a selected earnings stream to derive an overall value for a business. The value of the net assets of the business will be compared to the cash flow valuation and may be adjusted upward or downward. For example: if the earnings based valuation is less than the net asset value, an upward adjustment may be in order. Conversely, if the net assets are negligible, a downward adjustment is more likely to occur.

Many appraisers typically use a common range of multiples to arrive at a “ballpark” indication of value (for example, 4 to 6 times EBITDA). While this approach is commonplace, an in-depth valuation of the subject company will produce a more accurate result. There are too many intangible factors to be considered to rely solely on the capitalization of earnings. Of course, the ultimate value of a company will be determined by the marketplace, which can greatly differ from a seller’s expectation, as well as the expectations of potential acquirers.

It is not uncommon for business owners to have an inflated sense of value of their company. This could be due to a variety of factors including emotional attachment to the business, unwillingness to accept the impact of the risk factors of the business, outside influence from previous market conditions, incorrect conclusion of normalized earnings, comparable transactions, etc. Conversely, acquirers often undervalue businesses. In their quest to “buy right” they often end up paying a lower multiple for a company with serious negative factors, while passing up on higher multiple opportunities, which, due to the quality, are actually better buys.

Valuation is a complex process. Owners and buyers will be well served if they rely on professional advisors such as their accountants, business appraisers, intermediaries or investment bankers.

If you are considering entering the world of franchising, an important consideration is assessing the value of the business. All of the following factors either affect or help determine valuations of typical franchise operations:

1. Franchise Agreements:

Typically, franchise agreements can cover a period of twenty years; sometimes with added options. In most situations where a franchise unit has fewer than ten years remaining on the agreement (and options, if any), the value would diminish proportionately.

2. Territory Exclusivity:

Many franchisors do not, as a matter of course, provide an “exclusive” to franchisees within a given territory. More commonly, however, the franchisor will offer a franchisee limited protection for five years, during which time only he or she will be allowed to expand operation to additional units. Even limited protection can be assigned some value; any current territorial rights may have additional — and significant — value.

3. Business Hours

Potential franchisees should consider operating hours when assessing the value of a business. Business in general, and franchise operations in particular, are staying open for increasingly longer periods — some operate 24 hours a day, seven days a week. Locations in certain areas — city centers, bus stations, train depots — may open for shorter hours and fewer days. Since most business owners/managers would prefer the less demanding hours of operation, a premium value will be placed on these units.

4. Location:

This is the most obvious variable. A franchise operation in a suburban or small-town setting has a higher value than one in an inner-city or high-crime-rate area, regardless of other similarities (rent, sales volume, etc.).

5. Cash Flow:

Surprisingly, profitability may not necessarily be the key factor in valuing a franchise operation. A demonstrated, well-documented cash flow can definitely add value to the unit; however, the smart buyer will also look at other variables, such as unusually low food costs or labor costs, sales history, and potential for growth or improvement under new management in determining the overall value. Extreme situations provide the obvious exceptions to importance of cash flow: where the cash flow is extraordinarily high, capitalization of earnings becomes a truer method of valuation; where the franchise is actually losing money due to inefficient management, there would be some reduction in value.

6. Leases:

Taking into consideration market variation, the typical rent will be set at approximately ten percent of retail sales. Modifications in value could result if the lease does not cover a period of at least ten years.

7. Remodeling:

Many franchise agreements will require units to be refurbished within a certain number of years (ten is typical), with the franchisee bearing the cost. Since these costs typically fall within a range from $75,000 to $150,000, potential franchisees should pay particular attention to where the operation stands on this timeline. For example, a unit due for remodeling in a year or less could be reduced in value by a fair percentage of the cost of the improvements. The total cost would not be deducted from the value, since these improvements would also be expected to improve business anywhere from five to twenty-five percent.