The right price for a business.by Scharfstein, Alan J.
When the owner of a mid-sized company decides to sell, he may turn to his CPA and ask the $64 question, "How much is it worth?" In trying to provide an answer, the CPA examines not only the company's financial statements, but also the many other factors that contribute to value. He or she uses one or more of several commonly accepted valuation methodologies to arrive at a fair price.
The CPA will recognize what the heavy hitters do. Companies worth over $20 million will engage Wall Street investment banking firms to go through a complicated procedure to arrive at a fair market value. They rely on public markets and price multiples and have the experience of a relatively efficient market from which to draw. The CPA may not recognize that today it is a virtual necessity for any company worth over $1 million to go through a similar procedure. Constantly changing tax laws, new environmental regulations and other socio-economic considerations may require more complex valuation methods in terms of both quantitative and qualitative factors. Selecting which method to use is a difficult decision; it may be appropriate at times to use several methods, depending on the purpose of the valuer's work.
While the end product of a valuation engagement is an amount expressed in dollars or a range of dollars, the generally used methodologies require significant application of judgment.
QUALITATIVE FACTORS--THE INTANGIBLES
The basic numbers from financial statements tell part of the story. But the stone must be turned over to get at real value. How did the numbers get where they are? what were the forces that caused this company to be successful or unsuccessful? Can these forces have a direct bearing on the true value of a company? Of course they can ! Qualitative factors are based on intangibles. How is a value placed on an intangible? it comes from years of valuation experience and a current, in-depth knowledge of tax laws, environmental issues and the market. How much is a patent on a particular piece of machinery worth? How much is the company worth without the patent rights?
While different valuation methods are necessary to determine basic numbers, the evaluation of intangibles is essential to arriving at a fair price for both buyer and seller. It is important to remember that a buyer's economics may differ greatly from those of the seller.
Now, about the intangibles that impact directly on the price a buyer might be willing to pay.
The longevity, stability and skill of the in-place work force is vitually important to a potential buyer. A company with many long-term employees has more value than one with heavy turnover. Buyers will also look carefully into current union relations to determine if labor is friendly or unfriendly. any buyers will not purchase union shops. A potential buyer wants some assurance that the growth of the business can be supported by the existing labor market.
A strong impact on the value of a business is its dependency on any one individual, especially the owner or a family member. The greater the level of professional management in a company, the less dependence on any one person, and thus the higher the multiple that may be applied to a basic price.
Publicly held businesses sell for higher prices than middle-market, privately-held ones because the transaction has little impact on the ongoing viability of the business. In many privately held firms, principals control sales, key clients, or suppliers.
The higher the level of technical skill or specific knowledge required to run a business, the smaller the pool of potential buyers. The more receptive a business is to professional management, the greater its market value.
A company's physical location and suitability to its application are important. The uniqueness of the property, such as a paper mill close to a major source of water power, adds to the value. A "grandfather clause" in a zoning law may also have an effect on pricing.
The term of a lease can affect the stability of future earnings. The assignability of a lease is critical, and if not properly addressed might render a business basically unsalable. Many leases are valued below current market. Although not on a balance sheet, they are assets that must be considered in a valuation.
The impact of recent environmental legislation is a most important factor in evaluating a business. Many states have enacted legislation that holds a current owner responsible for pollution that may have existed when the property was purchased. Without clearance from appropriate environmental agencies, many properties may not be sold. In some cases the cost of cleaning up existing pollution may prove prohibitive. Concern about future limiting legislation may cause buyers to discount values, even more than current laws or liability limits would demand.
A concentration of the business with any one customer or a dependency on any one supplier will impact negatively on the value of a business. A close review of the client and vendor list for this purpose is essential to valuation.
Being able to predict the stability of a business increases its value. Businesses that have shown a steady growth in earnings attract a premium. Businesses that have a wide earnings swing are considered more volatile and should be appropriately discounted. A stable income stream and steady growth is often the encouragement a buyer needs to move forward.
The ability of a company to find outside financing obviously increases its appeal. Banks like to lend against receivables, real estate, and to a lesser extent, equipment and specific use assets. The asset base of the company affects the appeal of the business.
The length of time a business has been established and its reputation in the marketplace often impact future growth. Although these goodwill factors should already be reflected in earnings, a subjective adjustment might be necessary.
Competition and Barriers to Entry
The nature and extent of competition impacts a company's value. The start-up time it would take a potential competitor to enter the industry, and barriers to entry including required capital, regulations and licensing, all clearly impact the risk level in a business.
Some protection against competition is afforded by patents, trademarks, or copyrights, which may guarantee an ongoing income stream. However, technology assessments must often be done to determine the value of these protections.
Liabilities inherent in the nature of a business are a major concern. From industries where contamination and poisoning are a problem, to industries where there is product liability; most businesses hedge these concerns through insurance. The extent and amount of insurance coverage in force must be carefully reviewed. Will it continue to be available?
Hard assets provide a safety net for a buyer or lender. If a business has to be liquidated, these assets are of critical importance. Hard assets also impact favorably on a lender's view of the business.
Many businesses have off-balance sheet" assets, such as copyrights, leasehold interest rights, and overfunded pension plans. These assets should be examined carefully. For example, in the case of the overfunded pension plan, an actuarial review may turn the overage into cash. On the other hand, an underfunded pension plan or failure to accrue post- retirement health benefits can result in potential liabilities to a buyer that may adversely affect the sale.
Having considered the intangibles, it is now time to value the business.
RECASTING THE FINANCIAL STATEMENTS
The first step in a valuation engagement is to recast both the balance sheet and income statement. Recasting is vitally important and entails:
* Removal of any investment assets and related liabilities, i.e., investment assets net worth. Investment assets, used for purposes of valuation are those assets not essential to the operation of the business. Adjustments are made for excess cash, CDs, excess inventory, and similar items. Real estate, although functional to the business, is generally considered an investment asset and imputed rent is deducted from earnings.
* Restatement of tangible assets, particularly machinery, equipment, and, if applicable real estate, to market value.
* Restatement of inventory to a current cost basis, i.e., removal of LIFO and other inventory reserves and "phantom inventory. "
The income statement is adjusted to normalize the company's operations. It is necessary to determine both a recast pre-tax income of the company as well as a discretionary cash flow available to a potential purchaser. In that normalization the CPA looks at the following:
Owners compensation. Is it fair in terms of what a professional manager would receive for similar work? Should fringe benefits of the owner and his or her family be included?
Depreciation This cost should be adjusted to reflect the ongoing capital requirements for asset replacement.
Real property lease payments Do they fairly reflect what the company will be paying to occupy its space on an ongoing basis?
A recasting of a typical company's income statement is shown in Exbibit 1.
The recasting is the start of most valuation methodologies. In the balance of the article, the most common methodologies are discussed. The recasted earnings are the basis of the market forces and excess earnings methodologies discussed in detail and illustrated in Exbibits 2 and 3 omitted. Other methodologies are presented in less detail.
The business valuation techniques presented are based upon recast pretax income or recast pretax discretionary tax flow. Utilizing pretax numbers allows the valuator to determine a business's value without prejudice as to the tax situation of that entity. The fact that a given corporation takes an aggressive tax posture or has the benefit of an expiring tax-loss carryforward should not impact a business valuation. Further, when determining the value of a business for a sale, the post- transaction tax liabilities of the company may well differ dramatically from its pre-transaction tax liabilities.
The Income Approach
There are generally four accepted methods under the income approach.
Market Forces Analysis Model. This model explicitly considers some of the intangible factors discussed previously. The first task is to compute factors in designated categories for the qualitative issues that affect market value. The valuator must study the business and the environment in which it operates to determine appropriate adjustments in the categories. From a maximum of 100% of the markets' expectations in each category, discount percentages are deducted to create a discount factor. This discount factor is then applied to the target value of discretionary earnings times a multiple, generally the number of years lending institutions would consider for financing. This results in an operating market force analysis value, representing the maximum value, in terms of earnings, that a reasonable buyer would pay.
The analysis value is added to investment assets net worth to arrive at the market forces analysis model value.
Excess Earnings or IRS" Method This frequently used method is based on capitalizing the excess earnings, after deducting a reasonable return or ownership cost for tangible assets used in business operations.
Among business valuation professionals no topic evokes as much discussion as that of determining appropriate capitalization rates. The rates as suggested in Rev. Rul. 68-609 are between 10% and 20%. Data from actual transactions indicated rates from 20% to over 60% are more appropriate.
The steps in the excess earnings method include:
* Preparation of a statement of discretionary pretax earnings;
* Determination of tangible assets values;
* Selection of a reasonable rate of return for each indicated category of tangible asset, multiplying to determine the income return for each category in total;
* Determination of excess pretax earnings by deducting the return on tangible assets from discretionary, pretax earnings;
* Determination of a rate of return from the public markets appropriate for intangible assets. This rate should consider restricted liquidity of tile business;
* Division of excess earnings by the rate of return;
* Determination of excess earnings value by adding the capitalized excess earnings as determined to the investment assets and value of tangible operational assets, with operational liabilities subtracted.
Discounted Future Earnings This method is generally used where a company's historical earnings do not properly reflect near future anticipated earnings. The impact of factors such as economic trends, management changes, and product line shifts on future earnings is considered. This method requires an estimate of the future earnings stream generated by the investment.
A discount rate is calculated including a premium for illiquidity, the probability of failure, and characteristics of ownership. This rate should be comparable to alternative investment rates such as high risk bonds, equipment leasing rates, and high growth mutual funds. The discounted future five to 10 years' earnings are calculated. investment assets and non-essential assets are added and liabilities subtracted, to arrive at the value of discounted future earnings.
Debt Capacity Method This income approach is often used as an "acid" test to determine whether, based upon a typical leverage, a contemplated sale price can support the indicated debt. It divides a normalized pre- tax earnings stream between owner financing and institutional or other available financing, to determine the cash flow that a business can support in an acquisition.
The Market Approach
All market approaches are based on benchmark ratios that use only certain variables from financial statements to generate values. They are therefore limited in scope. They do, however, provide a basis for reasonibility checks. They are also the methods most commonly used by sellers, purchasers and appraisers.
Two of the market approach methods use normalized discretionary earnings. Adjusting income statements to a normalized basis reflects the financial performance of the business over several past years.
Briefly, the following are four methods under the market approach.
Factored Discretionary Earnings For this method, apply a multiple to the discretionary earnings and add investment assets net of liabilities. The multiple used will vary by industry and by company size.
Factored Net Worth plus Discretionary Earnings. Discretionary earnings plus factored recast net worth is the basis for this method. A factor of one-half to two times, depending on capital and management structure, is generally used. Investment assets net worth is added to arrive at factored net worth plus discretionary earnings.
Comparative Business Sales Comparative data from the sale of companies in comparable industries, of similar size and financial performance, are reviewed to determine a proper earnings multiple. It is critical that the total sale price be considered. This must include purchase price, liabilities assumed, covenants not to compete and management contracts. Reported data on privately held business sales is often tainted, because these items are rarely included. It must be remembered that earnings multiples tend to increase as the size of the business increases.
Public Market Comparable. This method employs use of price/earnings multiples of stocks of companies of comparable size in similar industries. The multiple is applied to the weighted average earnings of the company.
The Asset Valuation Approach
There are two methods to be considered under the asset valuation approach.
Liquidation or Collateral Value This method is frequently used when a business is being discontinued or has been unprofitable and is likely to remain so.
Fair Market or Ongoing Business Value of assets. To estimate the minimum value of a viable business entity, determine the value of current operating assets, and investment assets plus fixed operating assets at market value, less operating liabilities, to arrive at fair- market net worth.
Review and evaluation of all intangibles will enable a CPA to decrease a client's risk in a sale. The more the risk is decreased, the greater the value of the business. The greater the protection of the income, the higher the price the business will bring. Not until intangibles are assessed and adjusted can a satisfactory price be determined.
No one method is appropriate in every situation. In most cases all methods should be reviewed. Once these calculations are completed, a determination should be made of whether one method properly reflects market value, or whether there should be a weighing of different methods to determine the value.
Alan J. Scharfstein, MBA, is President of DAK Corporate Investors; a firm specializing in mergers, acquisitions, and valuations of middle market companies. He is a lecturer on the valuation of privately held businesses and CPE courses.
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