Value Blog

The transaction databases that I use in the process of valuing businesses generally reflect that there is a discount for all cash deals.  Sellers are usually willing take less money if they get it up front.  I discussed with Marty Fishman, a business broker with Transworld Business Brokers, whether the way a buyer pays for a business changes the price.

There are generally three ways that a buyer can finance a transaction:

• Pay cash,
• Lender financing with some buyer cash, or
• Seller financing with some buyer cash.

The lender financing is financing from a bank based on the business operations and its assets, usually through an SBA program.  When buyers use home equity loans to finance businesses, the sellers view the transaction as a cash transaction.

Even though a seller receives the purchase price in cash in lender financed deals, the buyer does not usually receive a discount.  This is because the types of businesses that qualify for lender financing are sound businesses with good records.  The businesses may even have tangible assets which are part of the deal such as equipment or inventory.  Many of these businesses are even pre-qualified for financing, making them more in demand and more marketable.

So what does this mean in terms of the price that a buyer will pay for cash?  Cash deals are discounted between 5% and 20% according to Mr. Fishman.  The amount of the discount depends upon a number of factors.  Perhaps top of the list is the motivation of the seller.  Motivated sellers are willing to lower the price to sell the business quicker.  Cash deals will often close quicker than financed deals, with less risk of the deal falling apart.   The better businesses have lower discounts;  businesses with poorer records or that have been experiencing downward trends will have higher discounts for cash buyers than more profitable businesses with good records.

The bottom line is that buyers who get a discount for offering cash can negotiate based on the condition of the business and how motivated the seller is.  Good negotiators may get a better deal by understanding the business.

©2010 Florida Business Valuation Group

Within the valuation community the trend has been to refer to “minority” interests as non-controlling interests.  The issue is really whether an owner has control, not how much of a company he owns.  In determining whether an interest is in fact a controlling or non-controlling interest I consider both the rights granted by agreement and by law, as well as what goes on in the business.

Some of the benefits of having control include:

• The ability to elect directors and appoint management
• Determine management compensation and benefits
• Set policy and change the course of business
• Acquire or liquidate assets
• Make acquisitions of other companies
• Liquidate, dissolve, sell out or recapitalize the company
• Sell or acquire treasury shares
• Register the company’s stock for public offering
• Declare and pay dividends or make distributions to owners
• Change the articles of incorporation or bylaws

While some owners feel that control over dividends or distributions is one of the most important aspects of control,  it is not the only aspect which can impact ownership.

In evaluating whether an interest is controlling or non-controlling, I consider how much not having these benefits impact a non-controlling interest.  A few examples may illustrate when a non-controlling interest could be impacted:

• A partnership receives an above market offer for a piece of real estate it owns.  The partner who wants to sell owns 51%.  However, the partnership agreements provides that in order to sell the assets, at least 75% of the ownership must agree to the sale.  The other partners owning 49% refuses to sell.  The opportunity may be lost because the 51% partner does not have control.
• A 10% shareholder works for a company.  He has been paid a salary in the past.  However, his position and salary are eliminated by the management of the company.  He remains a shareholder, but does not have the control necessary to reinstate his position or pay himself a salary.
• An S Corporation, which passes through its income to its shareholders, had profits, but management refuses to disburse money for the owners to pay taxes.  The shareholders agreement says that management at its sole discretion will determine annual distributions.  A non-controlling shareholder cannot force a distribution.

These situations represent real life scenarios where controlling shareholders have been at a financial disadvantage as a result of their lack of control.  In some cases, owners who have more than 50% of the equity may still not have control.  In others, shareholder agreements can give owners with less than 50% ownership control over a company in the form of being appointed as management, the right to hold seat(s) on the board or by virtue of by other shareholders not having voting rights.

In general, non-controlling interests are worth less than controlling interests.  Depending upon the standard of value and purposes of the valuation, a discount for lack of control may apply.

©2010 Florida Business Valuation Group

A recent article in the Journal of Accountancy, “Four Options for Measuring Value Creation”, brought up some very good points regarding why the financial statements of a company are flawed as measures of value. The article lists a number of reasons, but top on the list is that value is future oriented, whereas most of the measures on financial statements are historically based. Value is based on anticipated future benefits.

So what does a balance sheet tell you about a business? A balance sheet typically has the historical net cost of the assets a business has acquired over time. The balance sheet does not tell you the type of assets, their age or condition. Older assets may be depreciated and have a very low book value, but still be fully functional in the business. The balance sheet does not indicate what future capital expenses will be to either replace old equipment or to support future growth. Intangible assets, including intellectual property and goodwill, are usually not reflected on the balance sheet even though they may have substantial value.

A balance sheet reports the liabilities of a company. Unless you are reading footnotes to the financial statement (assuming the financial statements have footnotes), the balance sheet usually does not tell you the terms of the liabilities or when they mature. It also does not reflect how old the payables are or whether the company has unused lines of credit. Understanding the obligations of a company is necessary in understanding its value.

Is value better reflected on the income statement of a company? Many people think that profitability, which is reflected on the income statement, the primary element contributing to value. There are two potential problems with this assumption. First profitability is not the same as cash flow. For example, necessary investments in capital expenses for new equipment can impact cash flow while having a minimal impact on profitability. The other issue is the assumption that the level of profitability reported will be sustainable. A business can have increasing sales over a prior year, but if its receivables are increasing at a faster pace, there could either be a problem with collections or the growth may not be sustainable.

Financial statements provide important, but limited information about a company.  Understanding the financial statements is only the beginning in the process of determining the value of a company.

©2009 Florida Business Valuation Group

When businesses are valued, the real estate is usually appraised separately by a real estate appraiser and then that value is used by the business appraiser in arriving at a value for the company.  Most business appraisers are not qualified or licensed to appraise real estate.

The value of an operating business includes the assets used in its operations to generate revenue and profits.   Real estate is usually considered separately from the operating business because investors have different return expectations for real estate, which is considered a less risky investment than ownership in a business enterprise.

In South Florida the cap rates for real estate are currently just over 7% according to a recent article in the South Florida Business Journal.  In contrast the rates for closely held businesses are much higher and can be well over 15% depending upon the business industry, the history and the future expectations for a company.

If the real estate were not segregated from the operating business in the valuation process, the real estate would be undervalued.   Businesses are generally riskier than owning real estate, so investors require higher returns.  The higher the rate, the lower the value.  Generally, real estate that generated $1,000 of cash flow would be worth more than a business that generated $1,000 of cash flow. 

When valuing a business, you may want to check with the business appraiser so that you can properly budget for any real estate appraisals that may be necessary as part of the valuation process.

© 2009 Florida Business Valuation Group

One of the approaches to valuing a business is the market approach.  This approach looks to either private transactions or publicly traded stock to develop an indicator of value, usually in the form of a multiple.   Is a single transaction representative of the value in the market?

With public companies, the marketplace allows for buyers and sellers to negotiate each transaction by using bidding system.  A buyer will indicate what he wants to pay for a stock and a seller will indicate what he wants to sell the stock for.  When buyers and sellers are matched, there is a sale.  The public stock exchanges provide an efficient system for trades.

When a public guideline company method is used to value a business, comparable companies are identified and the information from the market is used to develop a market value.  Because the data captures the prices paid in the market, it is considered to be a good proxy of fair market value.  Since there are many transactions for each company, it is not necessary that an appraiser use a large number of comparable publicly traded companies in applying this methodology.  (The IRS heavily favors using publicly traded companies as a basis for value in developing opinions of value.)

When comparable publicly traded companies are not available, we look to private markets.  Private markets are no where near as efficient as publicly traded markets.  Often, limited information is available about the sale and the company operations.  Private companies are not require to report information and most information available is from database services that collect the information from brokers and intermediaries.

Since private markets are not efficient, the sales prices usually reflect an investment value rather than fair market value.

With all these challenges, how do we use these private transactions to develop indicators of fair market value?  Using private transactions is based on the concept that when transactions for similar companies are looked at together, these values represent the market as a whole.  The values for companies sold at distressed prices offset the values for companies sold at premiums, resulting in a market value.

Since the private transaction methodology relies upon a group of transactions to extrapolate multiples representative of the entire market, it is necessary to have a sufficient number of transactions to achieve this.  The problem is there is no absolute number.  We know that you need more than five transactions to get a statistically valid multiple.  Most agree that you need more than ten transactions.  The obvious answer is the more the better. With more transactions, an appraiser is better able to analyze the data into groups and arrive at a multiple based on factors that are similar to the company being valued.

While a single transaction price may be representative of fair market value, it is not sufficient to prove fair market value.  Remember price does not necessary equal value.  Price is the negotiated amount at which a transaction takes place and can be influenced by non-market factors.

For more information on the market approach, click here.

©2009 Florida Business Valuation Group

A rule of thumb is defined in the International Glossary of Business Valuation Terms as “a mathematical formula developed from the relationship between price and certain variables based on experience, observation, hearsay, or a combination of these; usually industry specific.”  Typically they are representative of the average price paid in an industry.  So, it would appear that using a rule of thumb would provide a good estimate of the value of a company. Should Company B still be worth twice as much as Company A?

It is the appraiser’s job to look at the facts and circumstances of a particular business operation in arriving at a value.  This includes establishing how the business compares to others within its industry.  Rules of thumb are not a recognized valuation method because often there is insufficient information available about how the multiples were developed.  Some rules of thumb are supported by market data, and others are not.

If you are interested in researching rules of thumb for a particular industry there are a number of sources:

• 2009 Business Reference Guide, published by Business Brokers Press (www.bbpinc.com)
• Handbook of Small Business Valuation Formulas and Rules of Thumb/Third Edition by Glenn Desmond, published by Valuation Press, 1994.
• How to Value over 100 Closely Held Businesses, Fourth Edition, by Stephen M. Zamucen, MBA, CPA, CVA, ABV, CFE, published by The National Alliance of Consultants, Valuers and Analysts, 2002.
• Handbook of Business Valuation, Second Edition, edited by Thomas L. West and Jeffrey D. Jones, published by John Wiley & Sons, 1999.

Additional information is sometimes available from industry trade groups.

Use caution when using rules of thumb as some of them are dated and may not reflect current industry or economic conditions.

© 2009 Florida Business Valuation Group

I constantly get requests and questions about “informal” valuations or rough estimates of value.  In some cases, individuals are deciding whether to buy a business and they want a sanity check that they are not overpaying for the business.  In other cases, most often divorce, the parties are trying to settle a case at mediation, so they do not have the same requirements that they would to prove value if they went to trial.

Regardless of the purpose, an appraiser who follows standards of any of the generally accepted organizations will have to perform a valuation in compliance with those standards if they are determining value.  In other words, there are no shortcuts if the client wants a number from the appraiser.

The definition of a valuation is very broad.  It includes the use of valuation approaches and methodology as well as the application of the appraiser’s judgment.  The standards all indicate how the appraiser develops the value.  A number of the appraisal organizations refer to the section of the standards dealing with this as developmental standards.

So while a client looking to purchase a business may not see the “number” that he requests as being a valuation, it most likely is.

In situations of litigation, there is often confusion about the applicability of standards.  This arises because of a reporting exception in some of the standards.  The reporting exception provides that appraisers do not have to present his or her findings in compliance with the reporting standards.  The thought behind this is that in a litigation or controversy matter, the opposing party or trier of fact will adequately question the appraiser so that the relevant elements are disclosed, making the format of the report less important.

If you think about it, the reason to hire an appraiser to provide you with a value is for you to have something that you can rely upon.  If you do not need the number to rely upon, then you do not need the appraiser.  When you are relying on a value provided by an appraiser, it should be developed in accordance with applicable standards.  To perform a valuation requires a minimum amount of time, and that time translates to money.  While some situations may not seem to warrant the cost, if an independent appraisal is necessary, there is no other option.

© 2009 Florida Business Valuation Group

There are terms that are frequently used in valuation that have specific meanings.  A group of the appraisal organizations got together and created a glossary defining various terms, the International Glossary of Business Valuation Terms.  Definitions below are taken from the Glossary.

An appraisal is the same as a valuation, which is defined as “the act or process of determining the value of a business, business ownership interest, security or intangible asset.”

The three approaches to valuation are the asset approach, the income approach and the market approach.  Within each approach are various methodologies used in the process of business valuation.

The asset approach is “a general way of determining a value indication of a business, business ownership interest or security using one or more methods based on the value of the assets net of liabilities.”

The income approach is “a general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that covert anticipated economic benefits into a present single amount.”

The market approach is “a general way of determining a value indication of a business, business ownership interest, security or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities or intangible assets that have been sold.”

Discounted cash flow method is “a method within the income approach whereby the present value of expected economic benefits is calculated using a discount rate.”

Discount rate is “a rate of return used to covert a future monetary sum into a present value.” The discount rate converts future net income, earnings or cash flow to a present value.  The rate is used in a formula which takes into consideration the point in time in the future when the benefit is expected to be received.

Capitalization rate or cap rate is “any divisor (usually expressed as a percentage) used to convert anticipated economic benefits of a single period into value.”  In simple terms is a rate that is divided in an estimate of net income, earnings or cash flow for a single period to arrive at a value of a business or business interest under the income approach.  The higher the rate, the lower the value.

A multiple is “the inverse of a capitalization rate.”

These definitions are a start to understanding the terminology used by appraisers.  In future postings I will discuss the application of different approaches and methodology.

© 2009 Florida Business Valuation Group

The first step in the valuation process is to understand the concept of value. Value is often thought of as a definite number. This is a common misconception. Not only can value be expressed in terms of a range, different types of value create a range of values.

Each person’s perspective, goals and objectives can lead him or her to arrive at a different value. There are different types of value, which valuators refer to as standards of value. Depending upon the purpose of the valuation, different types of value may be relevant.

Most people are familiar with the term fair market value. This type of value is defined as what a willing buyer will pay a willing selling, both being reasonably informed of all relevant facts and entering into the transaction freely. Fair market value is used for estate and gift tax valuations. Value for litigation purposes can be either based on fair market value or fair value. There are other types of value as well.

One of the first steps in the valuation process is identifying the appropriate type of value for the intended purposes. Florida Business Valuation Group is available to assist you in determining the appropriate type of value for your circumstances. For more information on standards of value and the valuation process, please click here.

© 2009 Florida Business Valuation Group

Welcome to ValueBlog. Potential clients and clients often ask the same questions regarding value and the valuation process. The purpose of this blog is to help you by offering some answers to frequently asked questions on an ongoing basis.

As will be discussed further, all value is not the same and correspondingly the valuation process may be different depending upon the purpose of your valuation.  ValueBlog will address general issues.  Please consult a valuation professional regarding the specific circumstances of your situation.  If you have general questions regarding valuation, please post them here and we will answer those on ValueBlog that are of general interest.  Questions of a specific nature will be addressed off-line.

You can also visit our website www.floridabizval.com for additional information.

© 2009 Florida Business Valuation Group