Will appear on BV pages – RECENT VALUATION ARTICLES

Terminal Value Meets the Butcher and the Skilled Craftsmen

/in /by Exit Strategies

I got involved in a friendly debate with a business intermediary the other day. He was talking cynically about how easy it is to manipulate valuation results by playing games with the cost of capital and the growth rate. “It’s easier to slap an industry multiple to it, without all the fiction of precision,” he said. Specifically, he was objecting to “terminal value” for growth companies. In growth companies, terminal value can often comprise 50%-70% of total enterprise value, so he was right to call the assumptions into question. However, according to his reasoning the whole valuation exercise is built on sketchy technical grounds. With that logic a skilled surgeon could be labeled a murderous butcher, or an accomplished poet labeled a daydreamer who never amounts to anything.

What is terminal value?

Terminal value is an attempt to capture the long term sustainable growth rate of the company and discount the company’s cash flow by its cost of capital. When a company experiences high growth, it’s certain that it will eventually mature and slower growth will ensue. The rate of slowdown is hard to predict, so it’s true that these aren’t precise calculations and they have a degree of subjectivity. However, a skilled valuation analyst will take care in applying these variables, and will use other approaches and methods to test, validate and defend his or her assumptions.

Not all companies are created equal, yet very few companies can outgrow the economy on a sustainable basis. For company risk, or its cost of capital, each company will have fundamental factors that either raise or lower its risk profile. Company growth, as mentioned above, may experience periods of non-linear growth but ultimately hit a maturation point that will be closer to the level of overall economic growth. Three to five percent is often a very defensible sustainable growth rate, depending on the company’s fundamentals and sensitivity to the broader economy.

“One advantage that Exit Strategies has over other business appraisers is that we see regular deal flow and work with actual market participants.”

Through our M&A brokerage practice, we see regular deal flow and work with actual market participants. This means that in addition to databases, we have a current market view of how companies are being valued.  This helps us to gauge our income approach risk and growth assumptions with a market based view. We also consider an asset approach and make market adjustments to book value, though this approach generally is used to provide a floor to the valuation. However, it can come into play if a company isn’t using its assets efficiently and is generating sub-par returns on invested capital.

To summarize my long-winded reply to the intermediary, a skilled craftsmen has a large tool kit, knows what tools to use, when, and how to use them in each particular situation.

Exit Strategies brings independence and over 100 years of combined valuation and transaction expertise to every engagement. For a free confidential consultation on and M&A, exit planning or valuation need, please contact one of our senior advisors. 

Monday Morning Quarterbacking in Business Valuations

/in /by Jim Leonhard
Is hindsight appropriate in retrospective valuations? 
As business valuation experts, we are often retained to provide a conclusion of value as of a date that is in the past.  For example, valuations for estate tax filings often use the date of death, which can be as much as a year in the past.  Valuation dates for litigation cases can be even further in the past.
Normally, using hindsight is discouraged in business valuations — the expert is cautioned against considering hindsight his/her conclusion of value.  The American Institute of Certified Public Accountants (AICPA) issued a Statement on Standards for Valuation Services saying: “Generally, the valuation analyst should consider only circumstances existing at the valuation date. An event that could affect the value may occur subsequent to the valuation date; such an occurrence is referred to as a subsequent event. Subsequent events are indicative of conditions that were not known or knowable at the valuation date, including conditions that arose subsequent to the valuation date. The valuation would not be updated to reflect those events or conditions.”
Of particular concern to the valuation expert is a client’s potential bias resulting from their preference for a particular outcome.  For example, if the valuation is for an estate tax filing, the client may be seeking a low valuation to avoid estate taxes.  This could cause the client to provide projections of “future” performance, subsequent to the valuation date, that are low compared to what management would have likely forecast at the time of death.  This could be exacerbated if the expert were to take into account the company’s actual performance after the valuation date which may have been negatively impacted by events that were unknown and unknowable as of the valuation date.
In litigation cases that seek a valuation for a date many years in the past, the valuation analyst must diligently guard against allowing subsequent events to influence his/her conclusion of value.
This is not to say there are no legitimate circumstances where the use of hindsight is appropriate, but that is a topic for a subsequent blog.
 
For further information on this topic call or email Jim Leonhard in our Roseville, California office.

Asset Appraisals May be Needed to Support a Business Valuation

/in , /by Jim Leonhard

I recently valued a number businesses that required the appraisal of certain tangible assets, such as real estate and equipment – in one case its was an extensive library of manuals and maintenance specifications for a service business.  At what point do we look for a appraisal specialist with particular expertise to value such assets?  

The simple answer is, it depends on materiality.  If it is clear that the business enterprise value is well above the net tangible asset value, as evidenced by the market and/or income valuation methods, we may be able to rely upon the owner’s estimates or rough calculations of the market value of tangible assets. The answer can also depend on the intended use and intended users of the business valuation.
When the asset(s) in question have very significant value  that will impact the market and/or income approaches to value, or if one of the asset approach methodologies, such as net book value or liquidation value will be relied upon, we will request that a client obtain a third party appraisal of the asset(s) in question that we can incorporate into our business valuation.
Typical  Situations Where Asset Appraisals are Recommended
  • Real Estate Appraisals
    • the business owns real estate, e.g. for agricultural enterprises or a real estate partnerships
    • the business leases real estate from a related party and we need to ensure the business is paying market rent
  • Equipment appraisals
    • the business is capital intensive
    • it has a large amount of used equipment – making rough value calculations unreliable
  • Unique assets
    • the business has a significant amount of unusual assets that are not common to most organizations
  • Non-operating assets
    • non-operating assets are items that can be removed from the business without affecting business operations, e.g. an airplane owned by a construction business, or a vacation home
For more information about how asset appraisals are used in business valuations, please contact Jim Leonhard, CVA, at 916-800-2716 or jhleonhard@exitstrategiesgroup.com. 

Vaguely Right or Precisely Wrong about Cash Flow

/in , /by Al Statz

Al StatzWarren Buffet once quoted the economist John Maynard Keynes, “I would rather be vaguely right, than precisely wrong,” in describing how he determines the appropriate cash flow measure of a company.

Indeed, determining the value of a business is not a precise exercise.  However, neither is the process random guesswork. After assessing the facts and circumstances of the business, the appraiser’s goal is to find a value that represents what hypothetical or actual market participants could be expected to pay for the business or an equity interest therein.

When it comes to understanding financial performance, privately held businesses present several challenges not present in public companies. For beginners, private companies are not held to the same financial reporting standards. Hence, financial statement quality varies widely from business to business. Business appraisers and M&A advisors must look at the reported numbers and make a series of adjustments before applying valuation methods. Valuation analysts typically make four types of normalization adjustments to arrive at a true measure of cash flow (or some other economic benefit stream).

Four Types of Normalization Adjustments

  1. GAAP related — typically for comparison with industry peers
  2. Non-recurring and extraordinary items
  3. Non-operating assets, liabilities, income and expense
  4. Control-related — adjusting owner benefits to market or reasonable replacement values

Owners, investors, CPA’s, attorneys, lenders and other market participants are often surprised how much work goes into investigating and adjusting financial statements before business valuation methods can be applied. Often, the smaller and more closely held a business is, the more normalization work will be required.

“Often, the smaller and more closely held a business is, the more normalization work will be required.”

There are other areas where the need for investigation and professional judgement increases in small business valuation. Small private companies seldom have the same quality of systems, and usually have more reliance on few products, employees or customers management, which increases uncertainty and adds to the risk analysis. And they rarely have defensible growth projections. The growth rate and risk score affects the discount or capitalization rate used in the valuation. And using valuation simplistic formulas, “rules of thumb” or hearsay are almost sure to yield precisely wrong results. Whereas, an accredited and experienced appraiser using appropriate valuation analysis, professional judgement, objectivity and common sense will give you an opinion of value that more accurately reflects market reality.

Exit Strategies brings independence and over 100 years of combined professional expertise to every business valuation engagement. Contact Al Statz with any questions or for a free confidential consultation on a potential business valuation or M&A need.

Business Valuation: Step one in the sale process.

/in , , /by Louis Cionci

If you are considering selling your business, I would like to let you in on an M&A (merger and acquisition) professional’s insight. I have been involved in initiating and managing M&A transactions for over 15 years and have handled deals representing over $250 million in transaction value. Those transactions ranged from $2.6 mm to $90 mm. In addition, I was on a team that helped an international client acquire a $2.6 billion industry rival back in 2000.

Whether $2.6 million or $2.6 billion, these successful transactions started with a business valuation.  The sale or acquisition of a business is a multi-step process, and the first step in a successful transaction between a buyer and seller almost always begins with a professional business valuation. Steps that follow the valuation include, marketing the company, buyer due diligence, negotiating the deal, and the closing.
A business valuation is a critical step on both sides of the deal table. Normally, the seller will do the first valuation, to get an idea of their company’s market value and then decide upon a price range that would motivate them to sell. The seller will generally share their historical and projected financial information with a vetted buyer. The buyer can then apply their own specific investment requirements to the shared information. Both sides utilize their valuations to negotiate the deal.
In my experience, no matter the size of the deal, the first step in a successful M&A transaction is a business valuation.
 
For more information on business valuation for M&A transactions, Email Louis Cionci or call him at 707-778-2040.

Valuation: Theory, Practice and Reality

/in , /by Exit Strategies

I attended a luncheon last week where a private equity firm’s panelist claimed that business valuation is too theoretical and inappropriate in the transactional world.  I instinctively question broad-based statements like this, when I hear them; however I listened attentively. The panelist correctly asserted that most valuation firms focus on compliance and litigation work as opposed to transactions. However, his criticism of valuation work was illogical and inconsistent, and offered no better alternative.

To make his case he defined enterprise value in transactional terms as: what it would take to buy 100% (equity + debt) of the company excluding cash, in an arm’s length deal. Okay, so far this was sounding a lot like the willing buyer/willing seller concept of Fair Market Value.

He went on to discuss how firms are typically valued by valuation analysts. These were his assertions:

  1. The income approach, known as discounted cash flow (DCF), is too theoretical. I disagree. This approach seeks to price businesses by assigning a risk-based rate of return to the expected future income. Strategic buyers use the DCF approach whenever they expect non-linear growth in the business. In business valuation we determine value to a strategic buyer under the Investment Value standard. Risk assessment also very similar to what bankers and insurance people do, although evaluating the risk of a going concern involves qualitative assessments that are harder to quantify. Proper application of valuation theory, tempered by common sense can provide clear insight into fundamental value.
  2. Comparable transactions are the most important. This is consistent with business valuation theory, and I agree in concept. In reality, a lack of data and inconsistent reporting of private business transactions makes accurate comparisons difficult. Therefore, this approach is often used as a reality check against income approach results.
  3. The factors used to gauge a company’s debt capacity are very similar to analyzing equity value (like customer concentration, poor systems, etc.). Agreed. Again, it’s pricing the risk of the operation.  A bank won’t lend money to a risky firm, or if they do, terms and pricing will be more stringent. The income approach he decried as “too theoretical,” works the same way.

He went on to discuss the price ranges that he sees in transactions. Typically, he said, adjusted EV/EBITDA multiples range from 3.9 to 6.9. This range can be explained by varying degrees of profit margins, expected growth and risk, as well as potential synergistic benefits. But he gave no indication how to quantify these issues.

In the end, I suspect that the panelist just didn’t understand business valuation very well, and described the world as he sees it through a narrow lens.

Two concluding points:

First, when valuing your life’s work, all reasonable valuation approaches should be considered. One approach may be more appropriate than another. All approaches lend insight into value. It’s not an all or nothing exercise.

Second, don’t trust your business to someone who lacks valuation expertise, someone with a limited point of view, or someone who may have an agenda.

Exit Strategies brings independence and over 100 years of combined valuation and M&A transaction expertise to every engagement. Contact us for a free confidential consultation with one of our senior advisors.

Your Buy-Sell Agreement: In good shape? Needs a tune up? Or Disaster waiting to happen?

/in , , /by Bob Altieri

An Ounce of Prevention is Worth a Pound of Cure

I can’t tell you how many times I’ve heard from business owners and their spouses that a key person became disabled or died and left an operating closely-held business in turmoil. What, no Buy-Sell Agreement? Ask anyone who has been selling and appraising business for a number of years and they will tell you this sort of thing is common. All businesses with more than one shareholder should have a Buy-Sell Agreement (“BSA”) in place. Even when companies have BSAs, they are poorly written, causing divisive and expensive issues down the road.

All multi-owner businesses need a well-written BSA to transfer shares in a fair and efficient manner when a shareholder dies, becomes incapacitated, is involved in a marital dissolution, quits or is fired, retires, or the company enters bankruptcy (aka,”Trigger Events”).

Exit Strategies’ accredited appraisers perform numerous business valuations each year, and because this work requires us to review corporate documents, we can say with some authority that many privately-held companies have problematic Buy-Sell Agreements from business, funding and valuation perspectives. When we come across B-S Agreements (pun intended), most often the owners didn’t want to invest the money to do it properly, or they just didn’t understand how import it was to have a viable BSA in place at the outset. Unfortunately, those who experience costly litigation, internal disputes, business erosion and family problems learn a painful lesson later on.

Shareholders have three choices when deciding on how shares will be priced when one of the aforementioned trigger events occurs:

  1. Fixed Price: Shareholders agree on a set price. Unfortunately, the price is likely years out of date and the shareholders usually have not agreed on a way to update the price.
  2. Price Formula: Shareholders agree on a formula to calculate future pricing. Chances are, no one has calculated it lately and because of changes in the company, economic and industry conditions over time, the formula price may be higher or lower than fair market value at the time of the trigger event. Also, it’s often seen where the shareholders haven’t agreed on ways to make necessary/appropriate adjustments to the formula.
  3. Valuation Process: Shareholders agree on a process employing one or more appraisers to determine the value of shares using guidelines specified in the BSA. There are two types of process BSAa: Multiple Appraiser and Single Appraiser. Multiple appraiser agreements call for the selection of two or more appraisers to develop one, two, or three appraisals whose conclusions form the basis for the final price. If that process sounds time consuming, cumbersome and expensive, IT IS!! It can also be divisive. Single appraiser agreements call for the selection of one appraiser whose valuation sets the final price. The choices are to a) select the appraiser and value upon a trigger event; b) select the single appraiser now and value at the trigger event; or c) select the single appraiser now, value now, and of course value again when a trigger event occurs.

Our Recommendation is to SELECT ONE APPRAISER NOW and VALUE NOW

  • Select Now – If the shareholders creating the buy-sell agreement name the appraiser at the time of the agreement, all parties have a voice and can sign off on the selection. Early on, when everyone’s interests are aligned, this is a relatively easy decision to make. Doing it after a trigger event, when interests have diverged, is very difficult.
  • Value Now – Once selected, the chosen appraiser provides a baseline valuation, which is a fantastic way to put all shareholders on the same (price) page. We often provide a draft report, and give everyone time to provide comments for consideration before the report is finalized.

Why selecting a single appraiser now and appraising now is the best choice for closely-held companies when creating a Buy-Sell Agreement:

  1. The selected appraiser is viewed  as independent by everyone
  2. Because the appraiser must interpret the BSA language related to valuation when conducting the initial appraisal, any issues regarding lack of clarity or inconsistency with the owners’ intentions can be resolved up front
  3. The valuation process is observed by all shareholders at the outset, so they all know what will happen when a trigger event occurs (no surprises)
  4. The concluded value establishes a baseline price (no surprises)
  5. The selected appraiser maintains independence with respect to process and renders future valuations consistent with the BSA terms and prior reports
  6. Subsequent appraisals, either annually or at trigger events, should be less time consuming and less expensive
  7. Parties will likely gain confidence in the process
  8. Parties will always know the current value for the Buy-Sell agreement, which is helpful for personal or estate planning purposes
  9. The initial valuation gives the shareholders a roadmap to increasing value if that is their objective.
  10. The appraiser’s knowledge of the company and industry grows over time, enhancing confidence for all parties
  11. Creates a means of maintaining pricing for other transactions, thereby enhancing “the market” for a company’s shares


Valuation is a key piece of any shareholder buy-sell agreement. If you need help with the business valuation provisions of your buy-sell agreement, or need a valuation for a trigger event, feel free to Email Bob Altieri or call him at 916-905-5706. 

Court Chastens Expert Over Deficient Business Valuation

/in /by Al Statz

Sometimes courts face a hard choice, having to decide between equally compelling and competent valuations. Not so in a recent fair value proceeding in which the skills gap between the testifying experts made it easy for the court to pick the winner.

Use of the Valuation: Business Divorce

The petitioner and the respondent were the two owners of a New York company that installed solar energy panels on buildings. Business boomed, and the company enjoyed an 80% market share until competition increased, cutting that share to 11%. Also, there was uncertainty over the fate of federal and state tax incentives offered to users of the panels.

The owners began to argue over the direction of the business. The respondent submitted a strategic growth plan to the board of directors that proposed expanding into new markets. The board approved it over the petitioner’s objection, who then filed for dissolution of the company. The respondent opted for a buyout of the petitioner’s shares. Both sides presented expert testimony about the fair value of the petitioner’s interest.

Key Issue: Financial Forecast

Both appraisers calculated value under the income and market approaches but used different methodologies. Under the income approach, the petitioner’s expert performed a discounted cash flow (DCF) analysis. He used the five-year projections the management board had approved but applied a company-specific risk premium to account for “forecast risk.” At the end of the forecast period, he reduced the growth rates during the remainder of the 10-year discrete forecast to only inflationary growth in the terminal value. He studied the company’s financials and corporate structure and assessed the recently adopted business growth plan. He also researched the industry and found that New York State had extended the tax credits through 2016 and had started another program to incentivize consumers to install the panels. Greentech Media, a leading source of news and analysis of green technology, forecast 60% annual growth in the industry over the next three years. Also, the company’s 2013 revenue exceeded that of the previous year by 35%. The final value, weighting results from the income and market approaches, was $3.8 million, he concluded.

The respondent’s expert, on the other hand, used the capitalization of weighted earnings method. The court noted that this approach assumes that a company has long-term stable cash flow but that the expert conceded that the company’s cash flows and earnings were not consistent during the preceding four years. He also said that the DCF was his preferred method. The court discredited his valuation. It pointed to multiple flaws, including the expert’s failure to include either a growth rate or management projections. He was unaware of the board’s growth strategy plan and did not know that the board had decided to reinvest dividends in the company to stimulate growth. According to the court, he “severely underestimated even his client’s own projections.” The court’s verdict regarding the respondent expert’s market-based analysis was even harsher. It had “severe deficiencies” that prevented calculating a credible fair value for the company, the court said.

Except for a slight adjustment for the marketability discount, the court adopted the petitioner expert’s $3.8 million value.

A full discussion of Wright v. Irish (Hudson Valley Clean Energy, Inc.), 2014 N.Y. Sup. Ct. Index No. 2111/2014 (Nov. 7, 2014) can be found in the January issue of BVR’s Business Valuation Update.

Exit Strategies’ five accredited business valuation experts use appropriate financial forecasting and valuation methods to deliver accurate and defensible valuations.  Feel free to call us for a confidential discussion of your business valuation or brokerage needs.  Contact Al Statz at 707-778-2040.

Upcoming Event: Valuing a Business for Estate Purposes

/in , /by Al Statz
Society of California Accountants North Bay Chapter Annual Estate & Trust Update
At the Sheraton Sonoma County
 
My background as a business valuation expert, M&A advisor, corporate development executive and business owner allows me to bring a wealth of knowledge and first-hand experience to closely held and family business owners as they consider their exit options and plan successful ownership transfers. I enjoy educating business owners  on these topics, and sharing my expertise with accountants, attorneys, lenders and wealth management professionals. And with baby boomer retirements on the rise, industry groups  are increasingly looking for experts to educate their members. 
 
If you want to explore booking me to speak to your group or association, Email or call me at 707-778-2040. 

The Importance of a Credible and Competent Valuation Expert

/in , /by Al Statz

Al StatzThe need for business valuation arises in many circumstances ranging from dispute resolution, to estate planning, to the sale of a business to name only a few.  As in all professional disciplines, it is important to hire a practitioner who is fully trained, able to discern relevant facts, and abreast of current best practices. Consider the following New York Supreme Court case.*

Adelstein v. Finest Food Distributing Co

Two brothers and their uncle each owned a one-third interest in a distribution business.  The brothers had offered to buy out the uncle. The uncle refused, the relationship deteriorated, and the case became a matter for the New York courts to decide.

The Brothers’ Expert

The expert for the brothers was a CPA lacking a business valuation credential, who had reportedly performed about 50 business valuations. His valuation report was three pages in length, based on a review of the company’s tax returns, and conversations with its accountant and its principals.  He chose an income approach, using the capitalized income method.  His rationale for using just one approach was that he couldn’t find comparable market transactions and that the company was not public. Normalizing adjustments produced an income stream of $206,000. A derived 20% capitalization rate was based upon company-specific risk factors such as customer concentration and limited management; applied a 20% discount for lack of marketability. He concluded the uncle’s one-third interest was worth $230,000.

The Uncle’s Expert

The uncle’s expert was a credentialed business appraiser.  His review included tax returns, general ledger, bank statements, and sales reports.  He found sales had doubled, gross margin declined, while officer compensation increased from $0 to $500,000. Further due diligence revealed 20% of sales were cash payments not recorded on the books. Analysis of sales reports found unrecorded sales of almost $1 million.  Additionally, he imputed industry gross margins of 35% versus 25% company reported margins.  The income approach produced a normalized income stream of $486,000, a 12% capitalization rate, a 5% discount, and a $4,050,000 value. As a sanity check, he applied a market approach using transaction data commonly accessed by professional business appraisers. In applying market multiples for sales, gross profit, and EBITDA he found a range of values between $3,990,000 and $4,191,000. He gave a 70% weight to the income derived value; 10% weight to each market derived value.  He concluded the uncle’s one-third interest was worth $1,287,000.

The Court’s Decision

The court affirmed the uncle’s expert citing his “credibility and reliability of valuation methods.”  Specifically, the court noted his qualifications, the use of more than one valuation method, and more objective and rigorous due diligence to support his conclusion.  Importantly, the uncle’s expert also demonstrated an understanding of state law on the applicability of minority discounts.

This case illustrates the wide range of business valuations and experts found out there in the real world.  More often than not, relying on a cursory review of an entity’s operations and a single method of valuation will omit key value determinants.

Accurate valuation requires an understanding of professional valuation standards and a rigorous analytical process that can be clearly explained and understood. Whatever the intended use of a business valuation, working with a trustworthy, experienced and accredited valuation professional usually provides the most accurate and defensible result.

* Adelstein v. Finest Food Distributing Co., 2014 N.Y. App. Div. LEXIS 2542 (April 16, 2014); Matter of Adelstein v. Finest Food Distributing Co., 2011 N.Y. LEXIS 5956 (Nov. 3, 2011)

Exit Strategies’ team of accredited business valuation experts have over 100 years of combined experience.  Please contact us for a frank, confidential discussion about a potential business valuation, sale, merger or valuation need.