How Declining Revenue Can Affect The Value Of a Business
With the economic upheaval of the past year, many business owners are facing declining revenue. We thought this would be a good time to discuss how shrinking business volume may affect the value of your business.
Determinants of Value:
The key to preserving value is to preserve Earnings Before Interest, Income Taxes, Depreciation and Amortization – better known as “EBITDA” to the extent possible. (See Glossary for full definition of EBITDA.)
The two factors that transform Gross Revenues into EBITDA are Gross Margin (which is the net after variable costs) and Net Margin, which is what’s left after expenses are covered. EBITDA, for valuation purposes is the result of “recasting” which converts a normal income statement into a statement of “Normalized Net Operating Cash Flow”. This topic was discussed in detail in a previous blog post here.
Keep an eye on your margins:
There is a common tendency to look at just Gross Sales to get a feel of how your company is doing. Maintaining the same Gross Sales while experiencing decay in net margin means the value of your company is decaying as well.
Watch Your Pricing:
In declining markets, there appears to be a tendency to lower prices to attract business. While it may increase gross sales, the effect on net margins can be devastating. Price wars can often lead to bankruptcy.
Understand Your Accounting System:
Most small businesses do a poor job of cost accounting, especially in differentiating COGS items from fixed expense items. Your accounting system may make this difficult. You may need to develop some spreadsheets in Excel which better reflect this distribution. Theoretically, gross margin percentages should remain about the same regardless of the volume of sales, and are more closely determined by pricing than any other factor. In cases of declining sales, it is the Fixed Expenses which can really destroy cash flow, which are overlooked until it is too late. Many businesses, in hope of a recovery, are reluctant to cut overhead – meaning employees mostly, and this can have a devastating effect on EBITDA. It is hard to cut key employees, but sometimes in the interest of survival it is necessary – even if they will be difficult to replace once there is a business recovery.
Develop and Fine Tune a Marketing/Business Development Program:
Our experience shows us that a common problem for small businesses is the failure to develop and maintain effective marketing/business development programs. In most cases just doing what you did last year will not produce the benefits you need. There are experts around who know how to drive business, and the cost of doing so could be significantly less than the reduction in margins that occur when you try to compete by cutting prices. An effective marketing consultant can be figuratively worth his weight in gold.
Deleveraging will not Impact Value:
While deleveraging (eliminating debt) will improve your net income, it will not affect EBITDA – which is the cash flow before debt service. And EBITDA is the main determinant of asset value from the income approach in appraisals.
Conclusion
While declining sales is a frightening phenomenon, close management of margins can help mitigate its effects on cash flow and preserve business value. If you can ride out the storm, your company will be even stronger and well-poised to come out of the slump when economic conditions improve.
Personal/Professional Goodwill – How It Affects Value Of Small Business
Goodwill Defined. The term “Goodwill Value” is a term of art that is applied to the incremental increase in value of an enterprise over and above the simple replacement value of the fixed assets. Unless it is added to a balance sheet reflecting an actual purchase of goodwill in an acquisition, it almost never is seen on a balance sheet based upon Book Value. It is the primary reason for business appraisals. It is a necessary element to determine the actual Fair Market Value of a business enterprise.
Goodwill Has Two Basic Potential Components.
• The basic form of Goodwill is “Enterprise Goodwill.” It applies to the business as a whole and exists irrespective of the increment of value resulting from a key person’s personal knowledge, reputation, customer relationships, or any other attribute which resides in his persona. It generally reflects a value which would exist without the participation or contributions of one or more key officers or employees.
• Personal and Professional Goodwill are very similar and they attach to the individual that contributes them. Personal goodwill is associated with individuals. It is the part of increased earning capacity that results from the reputation, knowledge and skills of individual people, and is non transferable and unmarketable. An example would be the CEO of a small business that has long-term personal relationships with the customer base, which could (or likely would) be lost if the person no longer were to be involved in the business.
Similar to personal goodwill, professional goodwill is often characterized as ‘conceptually distinct from that associated with a trade or business’ and attached to the individual. It is usually associated with reputation and experience. In most professional practices, professional goodwill is largely dependent upon the skills and attributes of the individual practitioners.
Reasons for Valuing Personal/Professional Goodwill. There are really basically two purposes: marital dissolutions and sales of businesses.
Marital Dissolutions. The most common reason for an actual appraisal of personal/professional goodwill value is marital dissolutions. This is because it varies widely from state to state as determined by case law. The two issues are whether Enterprise Goodwill and/or Personal/Professional Goodwill are included in the marital estate. Our research shows the following:
• In 6 states neither personal/professional or enterprise goodwill is included in the marital estate.
• In 4 states the issues are undecided.
• In 40 states enterprise goodwill is included, but in 24 of these, personal/professional goodwill is not.
Sales of Businesses. Normally, a business appraisal obtained by a seller will not break down personal goodwill as separate from enterprise goodwill unless the entity is a C-Corporation. This is because normally any personal goodwill is mitigated in the purchase and sale agreement to provide a means whereby the buyer will “inherit” the personal goodwill of the seller. This is done with such tools as:
• Non-Competition Agreements
• Retaining the seller as a key employee for a defined period of time
• Partial buy in, with a buy out later.
The objective of any of the above tools is to create time and exposure to the buyer by the client or customer base to allow them to become inured to the purchaser.
The principal reason a seller will want to know what percentage of the total Goodwill Value is personal/professional is that these can often be mitigated prior to the sale by effectively transferring the personal/professional goodwill to key employees. This typically results in the buyer being willing to pay a higher price for the business.
If personal/professional goodwill is mitigated it also opens the field to investor-buyers as opposed to operator-buyers. For more valuable businesses, the investor-buyer is likely the most efficacious way to sell.
Splitting the Sale in the case of a C-corporation. The biggest problem for owners of C-corporations is the double taxation of capital gains upon a sale. First it is taxable to the corporation, then when distributed to the shareholders it is taxed again at the personal tax level. This is not the case with proprietorships, partnerships, LLCs or S-Corps.
However, where personal goodwill is part of the sale, it can be structured as two separate transactions. One is a sale of the C-corporation’s interest (either stock sale or asset sale) and the other is a personal sale of personal/professional goodwill, which will then be taxed only at the personal rate.
Post by: Gerald W. Barney MS, CSBA, CMEA
American ValueMetrics Corp.
www. Americanvaluemetrics.com
info@americanvaluemetrics.com
Understanding Recasting
There are various approaches to valuing companies. For privately-held companies that are established and generate income, normalized net operating cash flow is usually the starting point for valuation. All other qualitative issues related to the merits of a company, such as its market position, intellectual property, etc. can be factored in but the bottom line is that the more cash a company generates, the more it is worth. Business owners should understand that cash flow is not the same as the net income on your income statement. Normalized Net Operating Cash flow is derived by adjusting the income statement for certain items that are either non-cash related, or unusual or discretionary. This process of adjusting is called “recasting”. It takes an experienced analyst to do this correctly.
Normalized Operating Cash Flow: Normalized operating cash flow is the cash flow that can be expected of the company under “normal” circumstances. It excludes unusual and discretionary expenses, as well as non-cash items.
Adjusting the Income Statement: To calculate normalized operating cash flow, start with net income from the income statement. Then add back non-cash expenses such as depreciation and amortization, and discretionary items like interest (how a company is financed is a discretionary decision), charitable gifts, personal expenses, and rent that is greater than fair market rates. Non-recurring expenses such as a company move or unusual repair may also be added back. Adjustments can also be made for gains or losses on sales of assets and income or expenses not related to the operation of the business such as interest income.
Adjusting for Owners’ Compensation: Often owners compensate themselves more or less than “fair market compensation for owners’ work”, which is what the owner could expect to pay someone hired to perform the owner’s duties. The way to adjust for this is to add back the actual owners’ compensation, and subtract the fair market owners’ compensation.
Discretionary Cash Flow and EBITDA: After adding back the actual owners’ compensation (including other perquisites such as auto expenses, insurance, etc.) and the other adjustments mentioned above, the resulting figure is called Discretionary Cash Flow (DCF). It is one cash flow measure used in appraisals. After subtracting fair market owners’ compensation from the Discretionary Cash Flow, the second cash flow figure derived is Earnings Before Interest Taxes Depreciation and Amortization (EBITDA). EBITDA represents the normalized operating cash flow that can be expected from the business. By making these adjustments, companies can be using consistent measures of cash flow, whether it’s DCF or EBITDA.
Keeping Track of Expenses: Of course, this is all possible only if you have the ability to find all the adjustments to make. Some of them are automatic line items in most accounting systems, such as amortization, depreciation, and interest. Others, such as officers’ compensation, are available in others. Some may not be separately identifiable in any accounting system and must be tracked by either creating special accounts in your accounting system or by a manual method. Keeping track of your personal expenses in the company, as well as unusual or discretionary items, may be a worthwhile effort as it will help you enhance the value of your business in the long run.
Conclusion
After recasting the income statement with all adjustments to net income, the resulting normalized operating cash flow may be evaluated to determine the company’s worth. Companies with low net income but high debt service, equipment depreciation or other expenses may actually be worth more than they initially appear.
Post by: Gerald W. Barney MS, CSBA, CMEA and Joanna Coy BA, CMEA, SBA
American ValueMetrics Corp.
www. Americanvaluemetrics.com
info@americanvaluemetrics.com
Minority Discounts: Defend Them or Lose Them
Minority Interests are Worth Less Than Control Interests. It is simply a fact that minority interests in closely held companies are worth less, pro rata, than control interests. Minority interests are usually considered to be 50% or less. In appraisal terms this is the difference between Fair Value, and Fair Market Value. To illustrate the point, what would, say, a 10% interest in a closely held C-corporation be worth if the owner decided to try to sell it to a public buyer? The appropriate value would be Fair Market Value. The answer: not much. It likely pays no dividend. The only chance to recover the principal investment is upon sale of the entire company, and the minority shareholder likely has no control in that regard. Therefore the Fair Market Value of the minority interest would reflect a fairly deep discount from Fair Value – perhaps as high as an 85% discount depending on the circumstances. The size of the discount is dependent upon the impairments to control of marketability contained in bylaws, shareholder’s/partnership agreements, buy-sell agreements, etc.
This fact can be used to advantage to reduce taxes in gifts or transfers of interests as a part of estate planning. However these discounted values must be supported by a qualified appraisal.
What Recent Court Cases Have Shown: Cases brought to the Tax court in recent years have shed light on the relatively obscure subject of discounted values caused by reduced marketability and control for minority interests.
Prior to these cases, appraisers typically treated valuation of such discounts as a minor adjunct to the valuation of the basic (majority interest) position. Many either used “industry standards” for marketability discounts of, say, 35% without support, or they attempted to support these values with statistics from studies of restricted stock of public companies. The courts have rejected such valuations in closely held securities, and laid down some principles which, if adhered to in appraisals, should significantly limit the chances of litigation and in many cases, significantly increase the defensible size of the discount.
Full Analysis Required. Though the appropriateness of applying minority discounts has been universally accepted by the IRS and the courts, recent court decisions have shown a fair amount of disagreement over the means of quantifying them. IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities,” but it is silent on “exempted securities,” which make up the vast majority of privately held securities.) The cases indicate a complete analysis is required to effectively defend the discount! The cases also clearly indicate that reliance on data from public company transactions is not appropriate for closely held, exempt, non-registered securities. (stocks, partnership interests, LPs, and LLCs are all securities under the law.)
Lack of Control Discounts, for small privately held companies are magnified in comparison with publicly held companies for a simple reason – in privately held companies the only practicable way to recover the investment is liquidation (sale) of the company. Without control, an investor does not have the right to exercise this option. Thus minority interests in closely held companies are very difficult to sell. In practice, appraisers have attempted to base discounts for lack of control on control premium studies of public companies. The two are not the same at all.
The case of Mandelbaum v. Commissioner, T.C.M 1995-255 sets forth basic factors which might comprise the discount, but this list was not exclusive, and other factors may apply and be considered as the situation dictates. It states that a complete analysis must be done which is relevant to the subject. In principle, the analysis must address all relevant factors. It includes but is not limited to issues such as private vs. public sales of stock, dividend policy, economic outlook, management, control issues and policies, voting rights, restrictions on transfer, redemption or “put” policy, etc.
Control Discounts as Applied to Family Members Owning Shares. IRS Revenue Ruling 93-12 holds that a minority discount will not be disallowed (emphasis added) solely because a transferred interest, when aggregated with interest held by family members, would be part of a controlling interest.
Conclusion: The courts have indicated that the appraiser must conduct a complete, defensible analysis of the applicable issues upon which to base his decision.
More Information. A white paper which provides more detail on minority and control discounts including court case references can be accessed at:
http://americanvaluemetrics.com/Content/ValuationDiscountsWP-Final.pdf
Post By: Gerald W. Barney MS, CSBA, CMEA and Melisa Silverman, JD, CMEA, SBA
American ValueMetrics Corp.
www. Americanvaluemetrics.com
info@americanvaluemetrics.com
Announcement of Our New Guest Blogger
Harvard’s next Guest Blogger is Jerry Barney, possibly the most successful independent business valuation specialist in the history of entrepreneurship. One of these days you’ll need to put a price on your company and Jerry’s the man to do it.
After more than 3,000 valuations on a global basis, Jerry still answers his own phone and begins educating you right from the start about how he will determine the true value of your business. He’s generous with his time and his expertise so be ready to take notes so you can later review his words of wisdom accurately, to your benefit. I find it’s also a good idea to write your questions down before you call. His web site, www.americanvaluemetrics.com is a good place to start to familiarize yourself with the valuation process when you need to get an appraisal of your company.
In October, 2008, in one cataclysmic financial quake, every company in America – and around the world – lost a major percentage of its value. Small companies as well as big ones. Soon thereafter the whole science of valuing a business changed dramatically. As the credit markets seized up the rules changed, the norms changed, the multipliers changed, and we can expect more changes in regulations as the IRS code changes also.
In order to understand the details of how our companies are and will be valued in a post-10-08 world, I asked Jerry to tackle the subject in a series of posts on the HBS Blog. I’m happy to present this first post of his series and welcome Jerry to the wonderful world of blogging!
