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Alcohol and The Origins of Business Valuation

A seemingly salacious title to a blog post, but the Business Valuation industry originated from alcohol – or lack thereof.In 1920 with the enactment of prohibition many enterprises that were engaged in the alcoholic beverage business were allowed tax breaks by the U.S. Government for “damages” suffered.  In order to determine certain tax benefits to these businesses their “intangible value” or “goodwill” had to be determined.  Prior to this time it was commonly believed that the value in a business was essentially the value of its assets less its liabilities.But, as we know today, business value comes in many forms – although most notably in the cash and profits it generates, has generated, and will generate.  But goodwill is also imputed into a brand name, some special technology that may or may not have materialized into a market, and in a myriad of other ways.  Even a stable staff generates goodwill.As a direct result of prohibition the IRS published a document called the Appeals and Revenue Memorandum (or ARM) 34.  ARM 34 presented two novel ideas: 1) Goodwill exists if a business has earnings in excess of another “like business” and 2) Goodwill value is determined by calculating the “current value” of those excess earnings. These concepts formed the basis for the practice of business valuation today.  Additional questions, responses, and new sophisticated methods dealing with business valuation resulted.  Check us out over at Fair Market Valuations to find out more.Posted by: John Klearman, Fair Market Valuations

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Financial, Strategic, and Hybrid Buyers

Not all buyers are created equal. We could debate about the types of business buyers out there but, excluding individuals, lets distill buyers into three categories – financial buyers, strategic or synergistic buyers, and buyers with some DNA of both previously mentioned (or hybrid buyers).  In the merger and acquisition (M&A) world we frequently refer to a private equity group (PEG) as a financial buyer.  Why?  Well, PEGs are formed to pool resources from investors that may have an interest in “sector” investing.  Look at a private equity group website like Huron Capital and you’ll see terms that resemble investor terms – minimum EBITDA, Sectors Invested, etc.  A PEG may also be a synergistic investor depending upon what types of investments are in its portfolio.  A synergistic buyer, by contrast, may consider acquiring a company because it adds synergy to its existing business.  Consider Google’s acquisition of DoubleClick for $3.1B.  In order for the buyer to justify the acquisition there must be synergy.  Is a financial buyer better than a synergistic buyer or is a synergistic buyer better than a financial buyer?

There is no way to answer this because beauty is ultimately in the eye of the beholder.  But, to the extent one is selling into a firm with great synergy (whether a hybrid PEG or pure strategic acquirer) the value of the selling firm is likely to incrementally increase.  The simple reason for this is that highly synergistic buyers contemplate future discretionary cash flow of the selling business in their valuation decision.  You’ll recall from a recent post that I mentioned that valuation efforts are about analysis, but investment banking is about advocacy.  As a valuation analyst we only contemplate the notion that there is a willing buyer and a willing seller.  We blend into the mix the notion of “valuing” future cash flow to determine one element of value.  But ultimately the market will “make the decision” as to the value of the enterprise being sold.  The purpose of a valuation in M&A, though, is to provide a benchmark, just like a real estate appraisal for a VA loan (for a trusted source, check out valoanrates.com).  The purpose of M&A representation is to drive that number up.

For more information contact us at Fair Market Valuations.

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Business Valuation is about Measured Analysis – Business Divestiture is about Advocacy

business valuation & divestitureIf you’ve given any thought to selling your business it is important to understand the distinctive roles your advisor(s) must play.  Besides a CPA and Attorney, or sometimes a Financial Planner, the two key roles in the divestiture process are those of the Valuation Analyst and the Business Sales Intermediary (sometimes referred to as an M&A Investment Banker).  Early in the process of understanding if or even when you may choose to sell your business determining value is an analytical process.  The analyst looks at key and measurable drivers of value and applies that data to a variety of different models.  Certain assumptions are made during the process, like “a market exists” or “neither buyer nor prospective seller are under duress”.  Discount rate assumptions are made, and other mathematical assumptions, based on very specific methodology are made as well.  Moreover, the financials are recast for non-recurring and key discretionary items to present the business in a “normalized” state.  The analyst typically derives either a “Conclusion of Value” or a “Calculation of Value”.     

But when an owner decides to sell their business the role of the advisor is different.  While they will rely on business valuations, their role is to be your advocate in arguing every possible driver of the ultimate purchase price.  And every concept available in the M&A toolbox becomes a lever point to argue for higher price.  So, while the analysis uses models to consider value, the intermediary argues all lever points to prospective buyers.

Sometimes the individual doing the valuation is the intermediary.  In this specific case it is important that they are able to seamlessly transition from their valuation work to being the owner’s advocate.  For more information on this subtle distinction please contact us at 877-VALU-BIZ.

 

Posted by: John Klearman, Fair Market Valuations

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8.5 Ways to Increase Cash Flow

A group of intermediaries within our nationwide network of advisers (The Business House, Inc) has released a strong recommendations list on how to increase small business cash flows.  Following these tips can most certainly boost a company’s business valuation.  Below is a recap of the key points:

Cash Flow is KING:    Cash In – Cash Out = Cash Flow

  1. Organized Record Keeping (we harp on this topic in other posts) 
  2. Collect Money and Fees Upfront
  3. Collect Accounts Receivable
  4. Audit All Expenses Yearly
  5. Extend Supplier & Vendor Debts
  6. Examine Employees & Make Personal Cutbacks
  7. Review Capital Assets
  8. Decrease Non-necessary Spending
  9. Inventory Management & Transportation Costs

Every good business owner knows that cash flow is the life blood to their company’s existence.  When positioning a company for sale, positive cash flow is critical in determining a company’s fair market value.  For specific breakdowns of each area listed above, please click the link provided above. 

Know your value.  Know your business.
 

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Key factors influencing small business valuation

As a business owner, you obviously want to be cognizant of decisions and factors within your business that will positively or negatively influence its value.  Below is a breakdown of some key areas you can focus on today to ensure that your company’s value is protected should you ever need to conduct a business valuation and if you ever plan to sell:

  •  Maintain clean financial books and records
    • Keeping business and personal expenses separate is ideal.  For many small business owners, they treat the company’s cash flow like a personal checking account.  Often times family expenses beyond owner compensation are being paid by the business such as meals, vacations, automobile, gas, insurance, phones, etc.  When preparing a business to sell, not only would these “owner benefits” be reflected back into the company’s earnings, but it will also have to be explained to a potentially skeptical buyer.  Keeping these types of expenses separate is of value when owners want to avoid buyer skepticism.
    • Studies from major accounting firms and even our own experiences have indicated that companies with audited financials, or at least professionally managed books for small businesses, will consistently fetch a higher purchase price than those not well kept.  If it’s not documented, it’s not accounted for.
  • Achieve for positive trending
    • Typically, the most recent 3-5 years of performance and 2-3 projections will be the closest examined periods in determining a company’s value.  Showing positive trends and growth in both revenues, net income and “owner’s discretionary earnings” will have a significant impact on value.  When businesses suffer due to factors out of their control (industry dips, seasonal declines, etc) those can more easily be accounted for.  When the business declines due to lack of performance on its own accord in comparison to similar companies in a similar industry, this will certainly drop a company’s fair market value and strategic value.
    • Buyer’s are purchasing future cash flows and potential.  If you’re in a decline, why would a buyer pay a premium?  Many business owners, rightfully so, believe their company is worth much more than it is due to the time, sweat, and effort invested into their business.  Owners who can step away from the situation and evaluate their business from a buyer’s perspective will appreciate the fact that positively trending cash flow and a positive outlook into the future will make the company that much more attractive and valuable.
  • Profitable process chain
    • With today’s advances in technology and automation, a company’s systems and process chain requires evolution.  Business owners who accept change and readily adapt to more efficient and productive ways to operate their business will not only increase profits, but also building a system that can sustain additional growth will less operational costs required.  Such automation or process changes can greatly impact value as the future operational and profit prospects of the business or ideal.
    • If your company is involved in the production of a product or service, you should evaluate your company’s core strengths and weaknesses.  Many owner’s in today’s world are outsourcing elements of their process chain.  While letting go control of certain aspects of your business can prove daunting, owners who find strategic partners to produce or manufacture key processes in their business can become much more efficient, increase quality, profitability and customer satisfaction.  Identify opportunities and seek out expert partners who you can strategically outsource to.
  • Make the business less reliant on you
    • If you wanted to, could you take off on vacation of the next 2-3 weeks (minimum) and your company not skip a beat?  If not, strive for this goal.  When a company is heavily reliant on an owner who works “in” the business, it is more susceptible to a lower valuation.  This is certainly true for companies with less than 10 employees where often times the owner is the business.  In his or her absence, clients will leave and the company’s ability to function is all but paralyzed.  Owner’s who can develop sound processes, responsible management, and a value chain to serve clients will be able to step away from working “in” the business and work “on” the business.
    • When a small business owner sells, the buyer will typically step in to run the company, as opposed to hiring a manager to run it for them.  It is important that a current owner lay the foundation for a completely new individual to seamlessly walk into the business and have the ability to successfully run it within 3-6 months time.  Making it as easy on a buyer to take over management is key in maintain and creating value in your business.

There are certainly many other major factors that will influence the value of a business (goodwill, client acquisition efficiencies, competitive landscape, fixed assets, inventory etc), but some of the above examples you can address sooner rather than later for a positive business valuation.  Know your value, Know your business.  If you have any other tips or advice, please leave a comment.

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Business valuation for SBA Loans

SBA logoThe SBA’s Standard Operating Procedures (SOP) was recently updated and released.  It is more streamlined and condensed, allowing for easier reference to and understanding of guidelines.

One specific area we want to highlight is the requirement of an independent, third party business valuation for SBA loans exceeding $350,000.  Here is the exert:

(i) Business Valuation

(a) Determining the value of a business is the key component to the analysis of any loan application for a change of ownership. The need for an accurate valuation is true regardless of whether the financing is structured as an asset purchase or a business purchase.

1. For loans less than $350,000, a lender may do its own valuation of the business begin sold to identify whether the seller is requiring a price that is not supported by the business’s historical performance.

2. For loans of $350,000 or more, the lender must obtain an independent business valuation from a qualified source.

As this emphasizes business valuation for a “change in ownership”, in many cases, a business valuation has already been conducted by the seller, assuming they are working with a legitimate intermediary/broker.  Some business brokers will conduct an analysis themselves, while others will assist in the gather and recasting of data, then bringing in a legitimate, third-party valuation firm for modelling, analysis and reporting. 

If an independent business valuation has not been performed, then banks need to seek a qualified source for valuation work.  A great example which validates such ‘Checks & Balances’ can be found in the following audit report conducted by the SBA where a lender provided a valuation, but it was tainted due to biased opinions and the subject company grossly overvalued, leading to a loan default.

We have a call into SBA headquarters for more information and will update everyone should any additional findings be of key relevance.

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Mid-market business valuation indicators strong

Most Americans continue to read, hear and see troubling news about the U.S. economic outlook.  Business owners need some reassurance that the sky is not falling, particularly for business owners considering the future sale of their business.  Today is a seller’s market!  But, cyclical indicators point that this window will not stay open forever.

Business valuation indicators are showing strong multiples for technology and software-related companies as well as those that cater to the baby boomer and senior demographics.  For the fifth consecutive year, Inc and Business Valuation Resources (the authority on valuation data, metrics, and comps) have prepared an interactive study to analyze the valuation of middle market companies (those with annual sales from $10 million $500 million).  Take a moment to visit this resource and see how your company stacks up compared to nearly 4,000 mid-market transactions analyzed over a 3-year window.

A word of caution.  While more than 140 industries are analyzed, you may not find an ideal comp for your business.  There is a big difference between a strategic buyer and a financial buyer.  Small businesses with sales of less than $10 million need to be aware that rule of thumb multiples based on adjusted EBITDA are typically less than middle market.  Per Rob Slee’s excellent book “Midas Managers”, firms considered small business generally see 2-4X adjusted EBITDA while those with sales in from $10MM to $100MM are more likely to see 5-7X.  Using a generic multiple is very dangerous for any business owner and is not recommended.  Determining your company’s market value through the process of an independent business valuation is THE first step and owner should take prior to taking their company to market.  Let’s take a $1MM annual sales, $200K discretionary cash flow business.  Using a simple 2-4X multiple leaves a gaping margin of error of $400,000!!!  Your business is most likely your most valuable asset.  Don’t fall prey to assumptions and being a penny-wise, pound foolish when it comes to business valuation.  Each buyer is different, with different motives for acquisition (financial, strategic, etc).  A business priced too high will not sale.  A business priced too low, well you know what happens then.

Know your value.  Know your business.

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Article: How to sell a million dollar business

CNN Money put out a great Q&A article a couple of weeks ago:  How to sell a million dollar business.  If you are planning or hoping to sell your 1-2 million dollar small business in the next 2-3 years, save this to your favorites.  Highlighted topics include:

  • A business broker can be your best ally in selling a business of that size
  • Questions to ask a business broker
  • Business broker fee and service expectations

Due to the overwhelming importance of the sale of a small business, conducting an independent business valuation is of utmost important in the first step to selling:  setting the price right.  Most quality brokers should be able to assist you in preparing for a third-party valuation, serving as a conduit.

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Business valuation and buy-sell agreements

The NY Times tackles a very important topic for today’s business owner:  what to do when partners want to split.  A buy-sell agreement protects all owners in a business for events when a minority, majority or equal owner decides or is forced to leave a business.  In most cases, a buy-sell agreement will include a provision for determining “fair market value” via a credible third-party business valuation.

If you own a business and share that ownership with other partners, it is important that you create measures to protect everyone’s best interests in the form of a buy-sell agreement.  Seek your attorney for such matters so that it is fair, carries goodwill and is responsible to all shareholders within your business.  In the absence of a buy-sell, ownership claims and buyouts are at jeopardy in most cases leading to litigation and exorbitant legal fees with few winners in the end.

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Business owners survey: business valuation & selling a business

If you own a business and are thinking about selling, it is important you recognize the value of a defined plan & strategy and the value of professional advisors.  An article featured on Financial Post summarizes a recent study of business owners who sold their business within the past 5 years (more than 100 business owners were surveyed about selling and what they would recommend to other business owners following their own personal experiences):

  • 74% recommend a professional business valuation to determine a fair, credible asking price
  • 71% recommend hiring a professional (such as a business broker) to coordinate & facilitate the entire selling process

A common sentiment amongst these business owners who decided to manage the entire process independent of outside assistance was “the process was often lonely, emotional and conducted without proper planning”.  Two other key quotes & findings from this study when business owners did it themselves:

  1. “Business owners are waiting till they get an offer before they address key issues in selling a business, which means they’re not negotiating from strength, and are leaving money on the table.”
  2. “….the former owners regret their failure to get the best deal not just for themselves, but for their management, staff and customers.”

If these trends are important to you and the sale of your business, take time to read the entire article and then strongly consider the involvement of professionals who understand and are experienced in the complexities of business valuation and business transactions.  website domain

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