Name: Exit Strategies Group, Inc.
Address: 531 E Washington St, Petaluma, CA, 94952, US
Telephone: 707-778-2040

Will appear on BV pages – RECENT VALUATION ARTICLES

What Does ChatGPT Think?

October 14, 2024/in Business Strategy, Business Valuation /by Joe Orlando

This October, I will celebrate my 12^th year as an Accredited Senior Appraiser (ASA) in Business Valuation with the American Society of Appraisers (also ASA). ASA members meet every year for an International Conference to discuss current topics and to share knowledge and best practices. I attended the most recent Conference in Portland, OR. A presentation entitled “The AI Revolution – Why it Matters to Appraisers & Application Strategies” by Greg Endicott of Strategic Value Group, LLC summarized a BVResources Survey on AI as follows:

1. Adoption: About 48% of business valuation (BV) firms are using AI, primarily for researching economic or industry conditions.

2. Popular Tools: ChatGPT is the most popular AI tool, used by70%of respondents. Other tools include Copilot, Bard (now Gemini), and Grammarly.

3. Concerns: 52%of firms are not using AI due to trust issues, data confidentiality concerns, and fear of AI “hallucinations.”

These takeaways were based on a survey of Business Valuation firms, not the general public. So, if about half of the BV firms surveyed are using AI, what can someone looking for a valuation get from asking a simple question into an AI engine?

Here is the free answer a business owner gets from ChatGPT:

The “rule of thumb” in valuing a business as a multiple of EBITDA generally follows broad guidelines, depending on the business’s size, industry, and growth potential. Here’s a quick overview of common multiples based on these factors:

Rule of Thumb by Business Type/Size

1. Small Businesses (less than $10 million in revenue):

o 3x – 5x EBITDA: Small businesses with modest revenue and growth potential usually command lower multiples due to higher perceived risks and less scalability.

2. Medium-sized businesses ($10 million – $100 million in revenue):

o 5x – 7x EBITDA: These companies tend to attract higher multiples as they are more established, often with stronger growth prospects and greater market presence.

3. Large Businesses (over $100 million in revenue):

o 7x – 10x EBITDA or more: Larger, well-established companies with stable cash flows, competitive advantages, and strong management teams often get higher multiples. These businesses are usually more attractive to institutional investors or private equity firms.

Rule of Thumb by Industry

1. Low-Growth or Capital-Intensive Industries:

o 3x – 5x EBITDA: Industries like manufacturing, construction, and retail, which often have higher fixed costs and lower growth potential, typically have lower multiples.

2. Moderate-Growth Industries:

o 5x – 7x EBITDA: Businesses in sectors like healthcare services, logistics, or consumer products generally attract mid-range multiples due to their stable but moderate growth prospects.

3. High-Growth Industries:

o 8x – 12x EBITDA or more: Technology, software, and biotech companies with high growth potential and scalable business models can see much higher multiples, sometimes exceeding 12x EBITDA, especially if they have recurring revenue models.

Simplified Rule of Thumb:

For most small and mid-sized businesses in stable industries, a 4x to 6x EBITDA multiple is a common rule of thumb.

So, does this artificial intelligence have it right? Sort of. However, the above ranges and rule of thumb come with the implied caveat, “it depends…”

1. It depends on the industry;

2. It depends on the size of the revenue;

3. It depends on the amount of EBITDA;

4. It depends on the future growth of the Company and

5. It depends on the risk in achieving this growth.

Historical Data in Support of ChatGPT Multiples

In testing these ChatGPT multiples, we looked at a database of actual transactions of lower middle market deals over the past few years. Below is a summary of rolling average EBITDA multiples for real deals up from the 4^th quarter of 2020 through the 2^nd Quarter of 2024. The data is compiled by GF Data, which collects and provides data primarily from private equity (PE) sponsors and other deal professionals involved in middle-market mergers and acquisitions (M&A). The data covers a range of metrics, including transaction multiples, leverage levels, and other deal terms, and is generally vetted and aggregated to protect the confidentiality of individual transactions while providing a robust data set for market analysis.

As databases go, this one is pretty good. It has a statistically significant dataset populated and used by dealmakers. I like to use these multiples often to value businesses with significant EBITDA of at least $2 million or more. Here are the average multiples for all industries based on transaction enterprise value (TEV), by industry and by EBITDA size.

Based on the above charts, GF Data does a good job supporting ChatGPT’s “rule of thumb” estimates for medium to large companies of 5x to 12x. However, because GF Data’s multiples are averages, they don’t specify outlier deals with lower and higher multiples than the 6.4x to 8.6x multiple ranges by industry.

For smaller deals, we have used the Business Reference Guide as a strong “pricing guide” as our first iteration of value when discussing with a potential client a rough estimate of the value of their small businesses.

Conclusion

My conclusion is that ChatGPT does of job of cobbling together a starting point for a discussion on the value of your business, but it doesn’t do the job of a business valuation appraiser or M&A advisor. Use ChatGPT like you use Zillow.com to value your house. The multiples above will give you a very rough estimate of the value of your business. However, this first iteration will not suffice for compliance (litigation as well as gift, estate, or income tax) or strategic (exit planning, assessment for sale, or merger) purposes.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, and strategic purposes. If you’d like help in this regard or have any related questions, you can reach Joe Orlando, ASA, at 503-925-5510 or jorlando@exitstrategiesgroup.com.

How to Purchase the Company You Work For

October 13, 2024/in Acquire a Business, Business Valuation /by Exit Strategies

For many C-Suite employees, owning the company they work for would be a dream come true. If you’ve been leading a successful private business or are a seasoned member of its executive team, acquiring that business may be a realistic goal.

Secure Funding

Typically, the biggest hurdle in buying a business is obtaining the cash/equity and securing the debt financing necessary to close the deal. The good news is that a healthy business is an attractive proposition for lenders and equity partners. You’ll need to demonstrate that the business has sufficient cash flow to service the debt and that you (and your team if applicable) have the skills and experience needed to lead the business forward.

A commercial bank loan is just one potential debt funding source. For smaller businesses, the Small Business Administration (SBA) offers government-backed loans with favorable terms, including long amortization schedules and low equity requirements. In some cases, the current owner may be willing to provide seller financing for a portion of the purchase which, if structured correctly, could act as “equity” in the deal.

An investment bank may be able to match you with private equity investors looking to support a management buyout.

Leverage Private Equity

Using your own cash and traditional debt financing may work for a small deal. But to acquired a larger more profitable company you are likely to need a Private Equity (PE) partner. PE firms specialize in investing in businesses with strong cash flows, growth potential and a proven and committed management team. They can enable you to obtain a minority ownership stake and lead the company.

In this scenario, the current owner often leads the sale process with the goal of helping you gain an equity stake. There are literally thousands of PE firms out there, and with you as part of the management succession plan, the pool of potential investors expands. Finding the right partner is the trick.

PE firms usually arrange the necessary debt financing and structure deals with an ownership stake for essential company leaders – through co-investment or some form of equity appreciation incentives. You may be able to put little to none of your own capital into the transaction and would likely not have to personally guarantee a loan.

Approach the Owner

If you are interested in owning part of the company you work for, its best to be proactive. The key is to approach the owners early on with a genuine and well-developed interest in acquiring the business. Expressing interest years before the owner plans to sell is okay. There’s nothing unprofessional about asking to own some or all of a business you care about.

Explain how your experience and leadership will ensure a smooth transition and continued success for the company. You may be best positioned to carry the owner’s legacy forward, maintain company values and culture, ensure customers are well taken care of, and keep the business in the local community.

If the owner wants to retire soon, you may solve the management succession problem. Even if they’re not planning to phase out, they may see the benefit in offering you a minority stake and keeping you invested in the business long term. Having a strong leadership team with a stake in the company’s future success can be a significant selling point for buyers.

Seek Professional Advice

Throughout the process, it’s essential to have experienced advisors in your corner. Engage an investment bank or M&A advisor to help with transaction and funding options. Consult an M&A attorney to navigate the legal aspects and an accountant to ensure that the deal is structured in a way that benefits both parties and minimizes potential tax implications.

Your boss should have their own set of advisors, including an experienced M&A advisor and an attorney to protect their interests and ensure a fair transaction.

Purchasing the company you work for is an exciting endeavor that requires careful planning, strategic funding, and a strong partnership with your current boss. Talk to your boss and, if they’re amenable, encourage them to consult with an M&A advisor. The right arrangement can enhance business value while providing you with the life-changing opportunity you desire.

For further information on this subject or to discuss a potential business sale, merger or acquisition need, confidentially, contact Al Statz at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Acquistition Offers Can Vary Widely

June 19, 2024/in Business Valuation, Sell a Business /by Al Statz

Beauty is in the eye of the beholder; and when it comes to selling your business, value is in the eye of interested buyers. 

As sell-side M&A advisors, we determine and agree on a probable selling price range with our clients, but we generally don’t set an asking price or discuss our clients’ value expectations with potential acquirers. Lower-middle-market businesses rarely go to market with an asking price.

Different buyers see different value in your business; so publishing an asking price is like setting a ceiling on what your business is worth.

Case in point …

We recently represented a company that received 10 indications of interest (IOIs), from a combination of strategic and financial buyers, as shown in the following graphic. An IOI is an initial bid in which interested buyers submit an approximate price and general terms and conditions for completing a deal. At this stage in the process, buyers have signed an NDA and read a thorough prospectus on your company prepared by us, but they haven’t visited your company, met with you and your leadership team in person, or done any significant due diligence.  

Notice the highest offer in this case was double the valuation of the lowest offer. This price range is fairly typical when we run a structured sale process.

These ten buyers saw exactly the same information; so why the dramatic range in value? In most cases, it comes down to motivation, synergies, perceived risk, and the buyer’s growth strategy.  

At the end of the day, value is relative. When selling, you want acquirers to determine the value of your business to them. The buyer who will pay the most is usually the one who can leverage your business to the greatest extent. That said, predicting who is going to step up and make the strongest offers is way harder than it sounds.

In this case, after reviewing the ten IOIs with our client, we set up management meetings with four finalist buyers who offered the best combination of price, terms, and strategic and cultural fit. After management meetings, one of the finalists dropped out of the process because they felt they had better acquisition opportunities. 

The other three finalists submitted final bids in the form of letters of intent (LOIs).  An LOI is a more formal and detailed document and is usually exclusive. In the end, we sold the company for over $33 million.  

To obtain the best price and terms available in the market, sellers need a structured sale process that brings all logical, qualified buyers to the table at the same time.

For further information on the M&A sale process or to discuss a potential business sale, merger or acquisition need, contact Exit Strategies Group’s founder and CEO Al Statz at 707-781-8580 or alstatz@exitstrategiesgroup.com. 

Exploring Donor-Advised Funds for Privately Held Business Owners’ Philanthropy

May 17, 2024/in Business Strategy, Business Valuation /by Joe Orlando

For business owners of privately held companies seeking a seamless and impactful way to contribute to charitable causes, Donor-Advised Funds (DAFs) have emerged as a philanthropic and tax-efficient solution. These vehicles offer a flexible and tax-efficient way to manage charitable donations, allowing donors to make contributions to a fund and then recommend grants to their favorite charities over time. Many people have successfully used DAFs to support the causes they care about, and there are numerous success stories available online.

According to the 2023 DAF report, contributions to DAFs reached an all-time high of $85.53 billion in 2022. These contributions have grown at a double-digit compound annual growth rate (CAGR) over the last five years, as detailed below.

Source: National Philanthropic Trust. 2023 Donor-Advised Fund Report

Even though DAFs are an effective tax-efficient vehicle to make contributions, special attention, and professional advice are required to obtain such tax benefits and contribute to a good cause. (NOTE: Exit Strategies does not provide tax advice but will work with your tax advisors to help value the assets contributed to a DAF.)

Contributions of Private Securities

Most of the valuations we perform for the transfer of equity to DAFs are associated with the transfer of private equity securities. These transfers into DAFs frequently occur immediately before a pre-arranged stock sale.

In these situations, the donor hopes to claim a charitable deduction for the full fair market value of the gifted stock. However, because the sale of private securities always has risk, a qualified appraiser must pay special attention to discounts associated with a lack of liquidity (or a lack of control and marketability) that lowers the value of the donation to the Fair Market Value at the date of the gift rather than the anticipated timing of the income to the DAF. The appraiser must analyze related documentation of the donation, such as the private company’s by-laws, an operating agreement, or a buy-sell agreement, to see if there are any transfer restrictions in support of these discounts.

Form 8283

The IRS requires Form 8283[1] to be filed with a tax return in support of the resulting tax deduction for the donor. This form needs to be signed by the donor and the recipient, as well as the certified appraiser, along with a thorough, USPAP-compliant report required by the IRS for their review.

IRS-Compliant Report

The IRS considers several factors while reviewing a business valuation report, including the completeness of the report, whether it adequately discloses the methodologies applied, and the information necessary for a reader to understand the report. The IRS assesses whether the appraiser possesses the necessary skills and credentials to conduct the business valuation.

If you are planning to contribute private equity or other illiquid assets to a DAF, professional advice and planning is critical. A team of advisors, including a tax attorney and your accountant, will help you navigate this process. ESGI would welcome the opportunity to be part of that team as the valuation expert who opines on the value of these donations. Our team of appraisers includes professionals with the ASA designation (an Accredited Senior Appraiser) issued by the American Society of Appraisers[2], and our opinions meet strict IRS requirements and have been successfully defended in IRS review.

Exit Strategies has certified appraisers who value control and minority ownership interests of private businesses for tax, financial reporting, and strategic purposes. If you’d like help in this regard or have any related questions, you can reach Joe Orlando, ASA, at 503-925-5510 or jorlando@exitstrategiesgroup.com.

[1] https://www.irs.gov/pub/irs-pdf/f8283.pdf

[2] https://www.appraisers.org/credentials/business-valuation

How to avoid being surprised by your business valuation

December 11, 2023/in Business Valuation, Exit Planning /by Exit Strategies

A significant number of business owners do not know how much their business is worth. That can be a source of conflict in the face of unfortunate events such as a divorce or a partnership separation. But it can be even more painful when the business owner plans to retire, only to find out the business isn’t worth as much as they expected.

These owners may have harbored lofty expectations based on personal attachment, historical performance, or their own inexperienced assessments, only to face a stark reality when confronted with a lower-than-expected valuation. It’s difficult news that can lead to dashed retirement dreams.

Maybe the owner has to work years longer than expected to build the business to the valuation they want and need. Worse yet, some business owners cling to their misplaced expectations, resisting calls from spouses or business partners to sell. Over time, distractions, frustrations, or external factors beyond their control can lead to declining business performance, and the business no longer becomes salable at all.

Let’s explore some of the reasons why business owners may experience such unwelcome surprises and shed light on the factors that can impact a business’s worth:

1. Emotional attachment: Business owners often have a personal and emotional attachment to their business, which skews their perception of its worth. Unfortunately the time, effort, and resources you’ve put into building a company do not always translate into transferrable value.

2. Lack of financial documentation: Another common problem that catches business owners off guard is a lack of proper financial documentation.

This happens frequently in bars, restaurants, and other cash-based operations. Sometimes owners make the mistake of not reporting income in order to save on taxes. But every dollar saved in annual taxes can cost three or four times (or more) as much in lost business value at the time of sale.

Even so, this is a problem even larger, non-cash businesses can deal with. If a business owner has not maintained accurate and up-to-date financial records—tracked according to standard accounting practices—it can be challenging to show the company’s true financial performance.

3. Overreliance on historical performance: Business owners might assume that historical financial performance automatically translates to current value. And it’s true that buyers will tune into the last 12 months’ financials. However, buyers are also looking at future earning potential.

They take various factors into account, including your company’s gross profit and EBITDA margins. Are your margins shrinking or growing? What about the market and the competitive landscape? If the business’s historical performance is not indicative of its current or future potential, the valuation might be lower than expected.

4. Concentration of risk: A business heavily reliant on a few key customers, suppliers, or employees poses a risk to potential buyers. If the value of the business is significantly tied to specific individuals or relationships that may not transfer upon a sale, that will impact the valuation.

5. Industry and market factors: External factors, such as changes in the industry or market conditions, can influence the value of a business. If the industry is experiencing a decline, changing trends, or disruptive technological advancements, the value of the business may be lower than anticipated.

6. Unrealistic growth projections: Business owners sometimes have overly optimistic growth projections that are not supported by market data or a realistic assessment of the business’s potential. If growth projections are unrealistic or lack substantiation, it can negatively impact the valuation.

It’s not good enough, for example, to say, “We don’t do any marketing. All you have to do is market the business and sales will grow.” Such a claim linked to a “hockey stick projection” (i.e., flat growth followed by a sharp increase) can hurt your credibility with buyers.

7. Lack of professional guidance: Without proper guidance from business advisors, such as an M&A advisor or valuation expert, owners may not fully understand the factors that impact what their business is worth. Seeking professional advice can help an owner manage expectations or, better yet, adjust business strategy toward supporting their valuation goals.

Each business is unique, and the factors affecting a valuation can vary. It’s generally a good idea to keep tabs on what your business is worth over the years. Consider getting an affordable estimate of value every two to three years so you know where your business stands. You don’t want to be caught off guard by any negative surprises at retirement time.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

Are You an Expert at What You Do?

October 16, 2023/in Business Strategy, Business Valuation /by Joe Orlando

So what is an expert and, more importantly, are you one? The term “expert” has many definitions. For anyone who has written a wedding toast or sat through a valedictorian’s speech you know how the next sentence starts…Webster defines an Expert as “one with a special skill or knowledge representing mastery of a particular subject.” If you click through the link you will notice an obsolete definition for the adjective: experienced.

This distinction is important to understand who can hold themselves out as experts in a particular field. In my field, Business Valuation, I consider myself both experienced and an expert. My certification as an Accredited Senior Appraiser through the American Society of Appraisers allows me to separate myself from other experts. For example, in valuing a business, a business broker may hold themselves up as an expert by applying pricing tools to determine the appropriate value of a business in a hypothetical transaction.

However, without the proper training and credentials, a business broker may rely on summary information for market multiples (i.e. the Business Reference Guide) and ignore the details of a transaction search. Without proper valuation training, they may also decide to exclude an income approach as a methodology better suited for a business generating strong cash flows. While the ASA, AICPA, and IRS standards dictate that my work as a credentialed appraiser meets the requirements of their compliance in opining to a value, anyone holding themselves up as an expert needs to follow a Federal Rule of Evidence Rule 702: Testimony by Expert Witnesses which states that;

A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if:

the expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue;
the testimony is based on sufficient facts or data;
the testimony is the product of reliable principles and methods; and
the expert has reliably applied the principles and methods to the facts of the case.

An Update and a Crackdown

However, an amendment to Federal Rule of Evidence 702 will take effect on December 1, 2023, to help clarify the qualifications of an expert witness. A crackdown using the terms of this amendment has already taken place with increased exclusions and reversals of a lower court’s decision to admit expert evidence. Here are the terms of the amended Rule 702 (changes either crossed out or in bold).

Amended Rule 702: Testimony by Expert Witnesses

A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise, if the proponent demonstrates to the court that it is more likely than not that:

the expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue;
the testimony is based on sufficient facts or data;
the testimony is the product of reliable principles and methods; and
the expert has reliably applied expert’s opinion reflects a reliable application of the principles and methods to the facts of the case.

While the above changes may seem minor, they are having an immediate impact on expert selection by attorneys and the exclusion of experts by judges. One of the top 50 law firms in the US, Perkins Coie, suggests that:

“While the rule has not changed extensively, the amendments clarify the standards federal courts should apply to the qualification of expert witnesses…In addition, counsel preparing expert witnesses may wish to ensure that the expert is prepared to defend the principles and methods used as appropriate and reliably applied to the given case.”

A Daubert Standard

Cornell Law School’s database of legal terms defines the Daubert Standard as follows:

“The ‘Daubert Standard’ provides a systematic framework for a trial court judge to assess the reliability and relevance of expert witness testimony before it is presented to a jury. Established in the 1993 U.S. Supreme Court case Daubert v. Merrell Dow Pharmaceuticals Inc., 509 U.S. 579 (1993), this standard transformed the landscape of expert testimony by placing the responsibility on trial judges to act as “gatekeepers” of scientific evidence.”

This standard was recently triggered in a bankruptcy case in South Carolina. The judge determined that the expert was qualified in this case but these challenges continue to occur.

Conclusion

I appreciate and respect someone with knowledge and experience holding themselves up as an expert. However, without the required credentials to pass the Daubert Standard test, I believe a judge, as the “gatekeeper” for the court, is more likely than not to exclude experts without an attorney appeal going forward.

Exit Strategies ten certified appraisers value control and minority ownership interests of private businesses for tax, financial reporting, and strategic purposes…and provide expert testimony. If you’d like help in this regard or have any related questions, you can reach Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.

Buy-Sell Agreement Valuation Resources

August 28, 2023/in Business Valuation, Buy-Sell Agreements /by Al Statz

Every business with two or more shareholders should have a buy-sell agreement. A buy-sell agreement is a legally binding contract that restricts and governs how shares are priced and transferred between shareholders or partners of closely-held businesses when certain trigger events occur. Arguably, valuation is the most important (and argued over) aspect of buy-sell transactions.

A good one-third of our business valuation work relates to internal equity transactions, and because this is an area of our practice that we are extremely involved in and passionate about, we’ve authored many articles about buy-sell agreements over the years. This post is a compendium of those articles, for easy reference:

Exit Strategies Group’s Buy-Sell Agreement Valuation Articles

Choices of Pricing Methodologies in Buy-Sell Agreements
Pros and Cons of Price Formulas in Buy-Sell Agreements
Hidden Problems with the Price Formula in Your Buy-Sell Agreement, and Solutions
How a Covenant not to Compete Affects Value in Buy-Sell Agreements
Does My Buy-Sell Agreement Establish Value for Estate Purposes?
Funding Your Buy-Sell Transactions
Four Questions Your Buy-Sell Agreement Should Answer
The Dismal D’s of Buy-Sell Agreements (shareholder departure, disinterest, divorce, death, disability, etc.)
Buy-Sell Agreement Categories (as defined by the relationship between the parties to the agreement, i.e., the individual owners and their business entity.)
Your Buy-Sell Agreement: In good shape? Needs a tune up? Or disaster waiting to happen?
Your Buy-Sell Agreement – Keep It Current Before It Costs You Money and Grief!
One Business Appraiser that All Parties Know and Trust

Finally, a summary of Exit Strategies Group’s services relating to buy-sell agreements.

MCLE Workshop for Attorneys

Our team also developed a free workshop for attorneys titled, “Avoiding Landmines in Buy-Sell Agreements: A Valuation Expert’s Perspective.” This program qualifies for 1.0 hour of MCLE credit and has been attended by over 250 attorneys so far. Contact Joe Orlando for further information.

Exit Strategies Group provides business valuation and consulting services to business owners and attorneys, to help them create, fix and administer buy-sell agreements (BSA’s). Feel free to check out these articles, and don’t hesitate to reach out to one of our senior appraisers with a related question or potential need.

Al Statz is the founder and President of Exit Strategies Group, Inc. For further information on this subject or to discuss an M&A, exit planning or business valuation question or need, Email Al or call him at 707-781-8580.

A Student of Business

July 18, 2023/in Business Strategy, Business Valuation /by Joe Orlando

A Difference of Opinions: Closely-Held vs. Venture-Backed Companies- Part 2 of 2

June 8, 2023/in Business Valuation /by Joe Orlando

In Part 1 of 2 of this blog, I spoke about my transition from valuing venture-backed technology startups to valuing owner-operated small to middle-market businesses with $2 million to $50 million in revenue. As part of that discussion, I set the stage for three differences in how these types of businesses are valued, specifically differences in Diligence, Tools, and Approaches. Part 1 looked at Diligence and Tools, and Part 2 will complete this discussion with a focus on differences in business valuation Approaches and Discounts.

Valuation Approaches:

A valuation Approach is a general way of determining value using one or more business valuation methods. Below is a summary of each of the three fundamental approaches to determining value: Asset Approach, Market Approach, and Income Approach.

The Asset Approach is based on the fair market value of a company’s underlying assets and liabilities. Generally speaking, the cost of duplicating or replacing each component is determined individually. Common asset-based methods are the a) Adjusted Book Value Method; b) Liquidation Value Method; and c) Replacement Cost Method.
The Market Approach is based on the principle of substitution, meaning that for any investment an investor considers, there exist other investments with similar characteristics that are acceptable substitutes. “Prudent individuals will not pay more for something than they would pay for an equally desirable substitute.” The principle of substitution is applied by studying the values of comparable (or guideline) businesses to estimate a value for the company being appraised.
The Income Approach considers the earnings capacity of a company. It values a business enterprise based on the present worth of its expected future benefit stream, adjusted for risk. The income approach operates on the theory that an investor will invest in businesses with similar investment characteristics, though not necessarily of the same business type.

Discounts

The values produced by the valuation methods used above may be subject to one or more adjustments referred to as discounts and premiums. The most common adjustments are control premiums, minority interest discounts (referred to as discounts for lack of control or “DLOC”), and discounts for lack of marketability (“DLOM”). Control refers to the extent to which an ownership interest controls the business entity. Marketability refers to liquidity, the extent to which an ownership interest can be sold quickly and turned into cash.

A controlling shareholder enjoys many benefits that are not enjoyed by minority interest owners. Minority interests are therefore usually worth less, often considerably less, than a proportionate share of the value of the total entity.[i] The types and magnitudes of the discounts/premiums applicable to an indicated value vary with the nature of the method, the data sources used to develop pricing multiples or rates of return, and the income normalization adjustments made. As noted above, our analysis using public company information assumes that any enterprise value is on a minority value because its capitalization is based on the value of a single share of minority equity.

Differences in Valuation Approaches and Methods and Discounts

An appraiser needs to consider all of these methods and potential discounts and decide which to use and which not to use. As outlined above, an appraiser’s approach and tools differ based on the scope of work and the type of company being valued.

This two-part blog offers a detailed review of how a business appraiser’s development of an opinion of value differs based on the ownership and size of the company being valued. I hope that this detail is both understandable and helpful.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, and strategic purposes. If you’d like help in this regard or have any related questions, you can reach Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.

[i] Jay E. Fishman, Shannon P. Pratt, J. Clifford Griffith, and James R. Hitchner. PPC’s Guide to Business Valuations, Twentieth Edition, (Fort Worth, TX: Thomson Reuters, 2010), Volume 2, p. 803.5.

A Difference of Opinions: Closely-Held vs. Venture-Backed Companies- Part 1 of 2

March 17, 2023/in Business Valuation /by Joe Orlando

In my transition from leading a valuation practice at an accounting firm to an M&A advisory firm, quickly realized significant differences between valuing venture-backed technology startups to valuing owner-operated small to middle-market businesses with between $2 million to $50 million in revenue. Over the last four years, I’ve concluded that there is a distinct and noticeable difference of opinions on the diligence, tools, and approaches used in valuing smaller, privately held companies. But before I dig into those differences, let’s define the fundamental difference between these two types of businesses:

Venture-Backed Companies – These companies are usually startups based on an incredible idea that hopes to disrupt existing industries and markets. Some of the Companies I valued in their infancy include Tesla, Okta, Fanatics, and Uninterrupted. Some of these valuations were done before a Subject Company generated its first dollar of revenue and all were flying below the radar at the time of valuation.

Privately-Held Companies – These companies include the companies that surround you every day from the local community market to the construction firm building homes in new developments to your local, downtown taproom. For me, they also include a growing number of owner-operated and family-owned craft beverage companies like wineries, craft breweries, distilleries, and cideries.

Now, let’s dig into the difference in how these different types of businesses are valued and how the type of diligence, tools, and valuation approaches used to value these various types of businesses differ significantly.

Exit Strategies Group prides itself on the platform and tools that it offers its appraisers and advisors for valuing companies for compliance, strategic, and M&A assessment purposes. In addition to our robust valuation model, we have a “Playbook” that is both a training and reference document that encompasses how we go about valuing and selling businesses. For this blog posting, I will only focus on the first two of these differences, diligence, and tools. Below is a “heat” matrix of how the differences I see in both:

Diligence:

All advisors have to follow strict guidelines regarding due diligence to meet compliance standards with the AICPA, USPAP, and other valuation standards. While the heat chart below shows differences between the diligence in valuing these two types of Subject Companies, they map to access to data and how a family business is managed differently than a venture-backed corporate startup.

Here are the biggest differences:

Access – When valuing venture-backed companies, the appraiser is usually dealing with senior financial management during diligence. Rarely does a founder take on this role for a business. For owner-operated businesses, the conversations before engagement and through to a final report almost always include the founder or owner as the “key person” in charge of the business.

Financial History – Venture-backed companies, by definition, lack any financial or operational history so it is almost impossible to analyze any trends over time. Owner-operated businesses usually have long histories that allow for this analysis.

Financial Forecast – What a startup lacks in historical financial history they make up for with long-term forecasts that look at the growth of their target market, their share of that market, and ultimate profitability over time. Owner-operators rarely provide long-term forecasts and bemoan the lack of visibility in trying to plan more than a budget year ahead.

Normalization – From the beginning, venture-backed companies are meant to be run in a corporate manner where senior managers (and founders) focus on their fiduciary responsibilities to shareholders. However, at times, there is an abuse of the policy of funds spent on “non-operating” or personal expenses. However, owner-operated companies are beholden to no one or have control of the business that allows them to run a business without a requirement for “market pricing” of everything from salaries and expenses. Therefore, it is almost always necessary to review the detail of an owner-operator’s financial statements to adjust for non-operating expenses, assets and liabilities, and above- or below-market salaries for themselves, and family members. The key question to ask in normalization is ”will a willing buyer need this expense or asset to run the business?”

Tools:

Similar to a carpenter who builds custom furniture compared to a construction worker building houses, valuation experts valuing these two types of businesses use different tools. The matrix below looks at some of these tools in greater detail.