5 Common Valuation Myths

business valuation

Business valuation is a complex discipline. Much of its lingo, logic and underlying mathematics can be incomprehensible to those outside the profession, giving rise to many misconceptions. So let’s set the record straight concerning five common valuation myths.


1. Net income and net free cash flow are synonymous.

Net income is an artificial accounting concept that is separate from cash flow. Net income includes a deduction for depreciation expense, which many small businesses base on accelerated tax schedules rather than assets’ useful lives. And net income excludes debt service, financing proceeds, owner distributions, capital expenditures and changes in working capital. Accordingly, net income is a poor substitute for net free cash flow.

For example, consider a fictitious business with obsolete fixed assets. Its equipment is in dire need of repair and replacement, because the owner pays himself excessive distributions in lieu of making regular capital improvements. On the surface, the company may appear more profitable than its competitors because its assets have been fully depreciated and current net income includes no depreciation expense.

Substituting net income for net free cash flow may overvalue this hypothetical business. Net income disregards the company’s need to update equipment and the shareholder’s reluctance to reinvest in future operations, whereas net free cash flow accounts for capital expenditures and working capital requirements. In sum, free cash flow is more inclusive and more relevant to value because it represents the amount of cash available to investors in excess of the current operating needs of a business-the essence of value.

2. Unprofitable companies aren’t worth much.

Historic profits are relevant in business valuation only to the extent that they may help predict future cash flow. For example, startups and high-tech ventures may incur losses until they are up and running. Despite being unprofitable, these businesses often possess value because of their potential to generate future cash flow. Hard assets and internally generated intangibles such as patents and proprietary software also contribute value.

Profit also may be artificially suppressed for tax reasons. For example, some professional service firms intentionally minimize net income for tax purposes through partner bonuses. Cash businesses, such as car washes or restaurants, may underreport cash receipts to evade taxes. Values for these companies are often higher than their reported income would otherwise indicate.

3. If its competitor sold for 1.5 times revenues two years ago, a business should sell similarly today.

Although comparable transactions may seem to provide objective, convenient valuation evidence, a lone transaction doesn’t provide a representative sample. A competitor’s sale might include buyer-specific synergies or unique terms, such as an earnout or employment contract for the seller. Consider, too, the reliability of the informant. Like fish stories, transaction details often become exaggerated.

Take, for example, public companies in the funeral industry. In the late 1990s, they aggressively acquire small funeral homes, driving industry pricing multiples to record highs. Although these roll-ups intended to introduce economies of scale and professional management, the strategy failed and forced many acquirers into bankruptcy or reorganization. Today the industry has largely recovered, and pricing multiples have returned to more realistic levels.

4. Tax status has no impact on value.

In several landmark cases-including Gross v. Commissioner, Wall v. Commissioner, Heck v. Commissioner and Adams v. Commissioner – the Tax Court accepted IRS arguments that S corporations (and other pass-through entities) are worth more than otherwise identical C corporations because of their numerous tax benefits.

The most notable advantage to electing Subchapter S status is exclusion from corporate-level income taxes, including corporate-level capital gains tax after a statutory holding period. And S corporation shareholders may receive tax-free distributions as long as their equity basis in the company remains positive.

When valuing S corporations, valuators must decide on a case-by-case basis whether to apply after-tax discount rates and pricing multiples to either tax-affected or pretax earnings. Factors to consider when making this complicated decision include the valuation’s purpose, relevant case law, the company’s distribution history and whether the business interest possesses elements of control.

5. Business value matters only when it’s time to buy or sell.

This is perhaps the biggest valuation myth of all. In truth, virtually every business could benefit from a regular valuation study. From an operational perspective, many business owners have no idea what their asset is worth. An informal valuation can teach management what drives value and ways to increase short- and long-term cash flow. Furthermore, a valuator can shed light on economic conditions and industry trends. This knowledge can improve operating efficiency and, ultimately, increase sales proceeds when the time comes.

Understanding business value is also an important part of contingency planning for key person life insurance, buy-sell agreements and succession plans.

One universal truth

If you’re confused about business valuation, you’re not alone-its ins and outs are frequently misunderstood. An experienced valuation professional can help clear up any myths and ensure your company is accurately appraised.

5 Ways to Prepare For Business Transaction Deal Breakers

Peter C. King VR CEO  
You’re buying a rival company. The transaction is nearly complete. At the last minute, an unexpected problem arises, and the deal falls apart. This nightmare scenario plays out countless times every year. But you greatly increase the odds of a smooth and successful acquisition by looking for potential deal breakers early in your due diligence efforts. The best time to address these situations is before the other company’sproblems become yours. Here are five potentially unanticipated deal breakers: 1. Evaluate litigation risk….

Creative Deal Structuring


Acquisition talks are proceeding smoothly. Then the subject of price comes up. The buyer thinks the seller’s asking price is based on overly optimistic financial projections. The seller believes the buyer’s valuation of his company is far too low. Is the deal dead? Not necessarily. An earnout agreement can help resolve the dispute when a buyer and seller disagree about the seller’s business prospects. They are especially useful when dealing with the unknown — when the target is young and unproven, or it is emerging from a difficult financial situation. In short, earnouts offer a way for the parties to bridge expectation gaps.

business dealUnderstand the benefits

In an earnout, a buyer makes a partial, upfront payment to the seller. With the payment comes a promise to pay the rest of an agreed-on amount if the target meets certain pre-established goals. Meeting these goals generally results in a higher price for the seller, while falling short of the goals may result in a lower price. A well-designed earnout carries advantages for both parties. For instance, the buyer can initiate a transaction with a relatively modest amount of cash. It also can avoid the risk of paying too much for a company unable to deliver on overly optimistic financial projections. Finally, an earnout can help make the transaction more valuable by significantly motivating the seller to achieve its promised results. The seller, meanwhile, can use an earnout to help negotiate a better asking price. An earnout can be particularly helpful when the seller believes that the company’s future results are likely to be much better than its current ones.

Structure the agreement solidly

Whether an earnout succeeds can depend on how well it’s structured. An ill-considered and vague agreement can turn a dispute over valuation into a dispute about the agreement itself. A common problem is drafting an earnout that covers an inadequate period. When this happens, the seller may try to quickly boost its earnings, even at the expense of the company’s long-term financial health. By expanding the earnout period, the buyer can collect more data to evaluate the target’s financial performance. Many experts say an earnout should reflect at least a year’s worth of results and perhaps as much as three years’ worth. Keep in mind, however, that the seller’s business becomes increasingly influenced by the buyer’s management — setting the stage for finger-pointing if the seller fails to meet the earnout’s terms. The earnout also should include the right measures of financial success. Gross sales figures provide one popular measure because they’re more difficult to manipulate than net sales. Net earnings, though a good long-term measure, are subject to many variables and can be misleading over a short period.

Achieve consensus quickly

Even the best-structured earnout needs occasional monitoring. A good way to keep the agreement on track and minimize the potential for later disputes is to include a provision for periodic audits. Audits help reassure the buyer that the target is using appropriate accounting methods and operating its business professionally. A poorly conceived earnout will fail to achieve a consensus between buyer and seller, who may interpret the same facts in vastly different ways. Thus, earnouts often include a dispute-resolution mechanism, such as arbitration, which can be a less expensive alternative to litigation.

Market Update for December 21st, 2012

The US Government continue to play with fire as the Reps et al at the end of the day yesterday determined it made sense to pull the vote for the Plan B fiscal cliff deal as they felt there was not enough support to get the deal passed.  That occurred around 9 last night and immediately markets and futures sold off.  Asia and Europe are off more than half a point while US futures are currently showing about a 1.50% decline pre-opening.  In contrast we are getting a nice bounce in the debt markets across the board by about a half a point at the long end of the curve which will help cushion the blow in portfolios today.

Gold is up about 3 bucks which is light under the circumstances and oil is off over 1% to just over $89 a barrel.

Economic news out of both Canada and the US showed continued economic recovery with CPI stable, personal spending and personal income both increasing vs. estimates.

RIM came with earnings last night and while the loss was less, revenues were better and the cash bleed has slowed, after looking into the numbers further, it would seem that the BB10 will have to be a home run in the New Year to keep this train rolling.  Interestingly, after the news was released last night the stock overseas rallied at first up about 10%.  This morning after dissemination it would seem that all the shine is gone and in the pre-market the stock is looking to open down about 11%.

Courtesy of:

Kenneth A. Dick, BA, CIM, CFP, FCSI
Portfolio Manager & Branch Manager
Independent Wealth Management


Business Morale Climbs, Housing Starts Down

This morning in Europe we are seeing business morale climbing again for the second month in a row which is encouraging and has markets over there trading higher by about a half a point.

In the US we got November housing starts and the number was down 3% vs. 2.5% estimated.  A bit of a blow but again the Sandy factor plays into it somewhat.  Interestingly, the building permits number for the month was higher by 3.6% vs. 0.8% estimated. US equity futures are showing a higher opening this morning up about a quarter point.

Staying in the US, the Government is selling off its stake in GM at a small loss but is giving the company back to the shareholders.

We are seeing Gold moving lower once again this morning after the big drop yesterday and oil is up about three quarters of a point.

Courtesy of:

Kenneth A. Dick, BA, CIM, CFP, FCSI
Portfolio Manager & Branch Manager
Independent Wealth Management


Every Business Is A Risky Business!

business riskEvery business faces risks, but some companies are riskier than others. Assessing  a company’s risk is an important part of estimating its value. Risk and value are inversely related. That is, the higher a company’s risk, the lower its value. Risk is a function of a company’s external threats and internal weaknesses, but these forces only tell part of the story. On the flip side, a business’s strengths and opportunities minimize risk and, therefore, build value. A Business Intermediary can help you further understand the relationship between risk and value, but remember when valuators focus exclusively on one side of the story, their conclusions are likely to be skewed. For example, to minimize an estate’s tax burden, an appraiser might unduly emphasize a company’s weaknesses and threats to justify excessive valuation discounts. Conversely, the IRS’s expert might downplay these negative elements and, instead, call attention to the business’s strengths and opportunities.

Framework for evaluating risk

Providing a complete, accurate depiction of a company’s future performance requires the valuator to consider both positive and negative aspects of its operations.A strengths, weaknesses, opportunities and threats (SWOT) analysis provides a four-pronged framework for analyzing risk that links a business’s internal strengths and weaknesses to the opportunities and threats in its external environment. This popular tool helps valuators organize their thoughts and provides a holistic risk assessment.

1.      External forces: opportunities and threats.

Before jumping head first into a company’s financial performance and operations, the valuator assesses the external environment in which a company operates.

Opportunities are favorable conditions that — if exploited — may enhance shareholder value. Alternatively, threats are barriers that jeopardize future performance. In many cases, management has little control over these external factors.

2.      Internal forces: strengths and weaknesses.

After the valuator understands the company’s external forces, he or she is ready to identify its internal strengths and weaknesses relative to its competitors’. Strengths are competitive advantages or core competencies that enhance value. In contrast, To complicate matters, strengths and weaknesses sometimes overlap. Consider former Disney CEO Michael Eisner. Although he fueled the company’s financial revival in the late 1980s and 1990s, Eisner’s inability to train a suitable successor has depressed the entertainment giant’s stock in recent years.

3.      Strategic management.

During the valuation process, the valuator also addresses whether a company recognizes and manages its strengths, weaknesses, opportunities and threats. Are the company’s short- and long-term goals congruent with these factors? Does management plan to mitigate threats and correct weaknesses? Is the company taking advantage of potential opportunities and exploiting its strengths? A company’s value can be adversely affected if management is unaware of these internal and external factors or if management fails to incorporate them into its strategic plans.

4.      Impact of information on value estimate.

Finally, valuators use the information obtained from their analyses to help them:

_ Select the appropriate valuation technique,

_ Forecast future income streams,

_ Decide on relevant selection criteria and other subjective adjustments under the market approach,

_ Build discount and capitalization rates when using the income approach, and

_ Quantify valuation discounts, such as discounts for lack of marketability and control.

Review and investigate

In adversarial situations, a valuator’s subjective decisions may come under attack. Attorneys and clients need to review valuators’ written reports to ensure that all risk factors have received adequate attention. They also should investigate exactly how these risk factors affect the appraiser’s computations and assess whether any factors have been double-counted. Above all else, a valuator’s subjective decisions should be well supported and reasonable. Contact a Business Intermediary to find out more about business value vs risk, buying a business or selling your existing business.


The VR Transaction Process: 20 Steps To A Successful Sale – Part 1

With over 30 years of experience in selling small to medium enterprises (SME), VR has developed a dynamic and effective Transaction Process to promote a win/win outcome for both Buyer and Seller.  Over the next two blog entries, we shall be sharing with you the 20 Step VR Process to Selling your business.  Here are the first 10 Steps to a successful sale:

1.     Initial Meeting:

The initial meeting serves as an introduction to VR and explanation on how VR can help maximize the value of your business and answer any questions. During this meeting your VR Intermediary will ask to review your business tax returns, company financials, brochures and sales materials, and any other pertinent information to understand your company.

Read the full article here.