Don’t Recycle Business Valuations

Recycle Bottles, Not Valuations

recycle business valuationsValuations are valid only for a specific time and purpose. Typically, a valuator explains the valuation’s scope in an engagement letter and again in the written report. Despite this, business owners sometimes mistakenly think they can save time and money by recycling old valuations for new purposes.

In fact, the unintended use of a valuator’s conclusion can diminish the report’s credibility. It may lead to misinformed business decisions, fiduciary breaches and embarrassing courtroom mishaps.

One wrong turn leads to another

To illustrate the perils of recycled valuations, consider Otto’s Auto Mall, a fictitious private business that reused a valuation three times to save on appraisal fees. Below are the four scenarios under which Otto used the valuation.

Gift scenario 1. Otto initially sought an appraisal when he gifted 10% of the auto mall to his daughter, Olivia, in 2001. The valuator estimated that the fair market value of the business interest was $68,000, including a 15% minority interest (or lack of control) discount and a 20% lack of marketability discount.

Dissenting shareholder scenario. At about the same time, the value of Otto’s Auto Mall was subject to debate in a lawsuit with a 10% minority shareholder.Without disclosing the fact to his valuator, Otto applied the value from the gift tax return to the dissenting shareholder’s interest.

But Otto didn’t understand that a different standard of value-fair value-applied in dissenting shareholder cases in his jurisdiction. Based on relevant legal precedent, his partner’s interest wasn’t subject to valuation discounts. Rather, it should have been valued on a controlling, marketable basis. Unfortunately, because Otto’s recycled report applied an inappropriate standard of value, the judge disregarded it entirely and, instead, relied exclusively on the opposing expert’s analysis.

Divorce scenario. A year later, Otto filed for divorce. To value his largest marital asset-a 90% interest in Otto’s Auto Mall-he turned again to the valuation prepared for gift tax purposes. Otto reviewed the valuator’s analysis and adjusted her conclusion for marketability and control discounts taken on the 10% interest. Accordingly, he conceded during settlement talks that his 90% business interest was worth $900,000.

But Otto failed to consider the issue of goodwill. In his state, personal goodwill is specifically excluded from the marital estate. If a valuator had advised Otto about this issue, he could have argued that elements of personal goodwill existed. For example, over the past 40 years, Otto had fostered relationships with repeat customers, personally guaranteed bank debt and directly managed the service department.

Without Otto’s continued support in these activities the business value would drop substantially. In addition, Otto had historically taken very little salary and had just taken distributions from the business. An appraiser with divorce experience might have helped him avoid the “double dip” by making appropriate compensation adjustments to the business’s income stream.

Again Otto didn’t contact his appraiser before recycling her report. Assuming that the auto mall’s value included $300,000 of goodwill and roughly one-third was directly attributable to Otto’s personal efforts, Otto unwittingly overvalued his 90% interest by approximately $90,000 ($900,000 minus $810,000). Further, he was ordered to pay alimony on the distributions from the business while also paying for the value of these distributions in the business valuation.

Gift scenario 2. The most recent wrongful reuse occurred in 2006 when Otto gifted a 10% interest to his son Oliver. He erroneously assumed that the company’s value hadn’t changed much since 2001 and recycled the original gift tax valuation one more time.

But over the previous five years, the local marketplace had changed dramatically. Urban sprawl had finally reached Otto’s town, bringing in four new dealerships and two national service station franchises. Otto also had retired and relinquished control to Olivia and Oliver, who were still learning the business and building relationships and reputability.

Despite the population growth, adverse risk factors significantly diminished the dealership’s value. The outdated report value stated on the gift tax return substantially overstated the value of Oliver’s 10% interest.

Think twice before recycling

Value is a function not only of the performance of the company, risk and the size of the business interest, but also of the valuation’s purpose and timing, as well as the relevant statutes and legal precedent. As this hypothetical example illustrates, recycled valuations can lead to significant errors.

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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.

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.