593 18 BUSINESS VALUATION Michael A. Crain It has been said that determining the value of an investment in a closely held business is similar to analyzing securities of public companies. The theories are similar and not overly complex on the surface. There are even Web sites that proclaim to be able to value a private business. But like so many things in the business world, the devil is in the details. The valuation of a closely held busi- ness depends on many variables. While the theories of valuation are not overly complicated, the accuracy of the valuation result is only as good as the vari- ables that go into it. The valuation of closely held businesses is often compli- cated because of the limitations of the underlying information and the way private businesses are operated. Unlike public companies, private businesses often do not have complete and accurate information available. Dollar for dol- lar, the time to accurately value most profitable private companies is out of proportion to the analysis of public-company securities. This is illustrated in the following case study that demonstrates the financial theories of business valuation and the level of information needed for an accurate result. For the past 20 years, Bob has owned and operated a manufacturing business that has grown significantly since its inception. Bob is approaching 60 years of age and his children do not appear capable of taking over the company. He is contemplating the future of the business at a time when he would like to slow down. One of his options is selling his business. Bob’s company, ACME Manu- facturing Inc. is a manufacturer of certain types of adhesives and sealants and has revenues of approximately $50 million. It has six manufacturing locations throughout the country. Bob owns 100% of the company’s common stock. He does not know what the company is worth, nor does he know how its value 594 Making Key Strategic Decisions would be determined. Bob asked his certified public accountant (CPA) about valuing the business. The CPA tells him that it would be most appropriate to engage someone who specializes in business valuations. After interviewing sev- eral candidates, Bob hires Victoria to appraise his business. The valuation date is December 31, 2000, and the standard of value is fair market value. Victoria explains the appraisal process and the scope of her work. THR EE APPROACHES TO VALUE Victoria tells Bob that the value of a business is determined by considering three approaches. 1. Income approach. 2. Market approach. 3. Asset (or cost) approach. The income approach is a general way of determining the value using a method to convert anticipated financial benefits, such as cash flows, into a present single amount. This approach is based on the concept that the value of something is its expected future benefits expressed in present value dollars. (A simple example of present value is that a dollar received a year from now is worth less than a dollar today.) The market approach is a general way of determining a value comparing the asset to similar assets that have been sold. For example, real estate ap- praisals using the market approach rely on the sales prices of comparable prop- erties. In business valuation, it is sometimes possible to locate similar businesses that have sold and are appropriate to use as guidelines in the appraisal. The asset approach is a general way of determining the value based on the individual values of the assets of that business less its liabilities. The company’s balance sheet serves as a starting point for this approach. The proper applica- tion requires that all of the business’s assets be identified. Often, the balance sheet prepared in accordance with general accepted accounting principals does not include assets that have been created within the company such as goodwill and other intangible assets. Once all the company assets and liabili- ties have been identified, each one is valued separately. DIFFERENT TYPES OF BUYERS Victoria explains to Bob that buyers have different motives for acquiring busi- nesses and they may be willing to pay different prices for the same business. Most buyer motives can be grouped into these categories: • Financial buyers. These buyers are primarily motivated by getting an ap- propriate rate of return on their investment. Financial buyers generally have a much broader range of investment alternatives than other types of Business Valuation 595 buyers. Also, financial buyers often have an exit strategy to sell their in- vestment at some time in the future. They usually pay fair market value (defined next). • Strategic/investment buyers. These buyers probably already know the company or already operate in its industry. Therefore, the number of strategic buyers for a particular business is typically more limited than the market of financial buyers. A strategic buyer is usually looking at in- tegrating its operations with the purchased business. Most of these buyers will pay a price that reflects certain synergies that are not readily avail- able to financial buyers. This price is called investment value, which is different than fair market value. The smallest of businesses, sometimes called “mom and pop businesses,” often have two other groups of buyers—lifestyle buyers and buyers of employ- ment. A lifestyle buyer is looking to acquire a business that gives him or her a desired lifestyle (e.g., a motel in the mountains). Another group of buyers of small businesses is primarily motivated to provide employment for the buyer and/or the family. Among strategic and financial buyers, strategic buyers will usually pay a higher price because of the anticipated synergies between the two businesses. After explaining the different types of buyers to Bob, Victoria discusses how it applies to ACME. Obviously, Bob would like to obtain the highest price possible if he sold his business. However, Victoria has no way to foresee who that buyer may be or that buyer’s strategic motives for buying ACME. There- fore, she is going to determine what a financial buyer would likely pay—the company’s “fair market value.” Practically, determining the fair market value will assist Bob in establishing a target minimum price to accept when selling ACME. If Bob can locate a particular strategic buyer who would pay a strate- gic price (or investment value), he will try to obtain a higher price. Bob asks Victoria to explain fair market value and how it differs from in- vestment value. She tells him that fair market value is defined as “the price, ex- pressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” 1 Fair market value contemplates what the “market” will pay. Investment value is the price a specific investor would pay based on individual requirements and expectations. It frequently reflects a higher price for the unique synergies between the buyer and company. AN OVERVIEW OF THE BUSINESS VALUATION PROCESS Victoria explains to Bob that a complete business appraisal is both a quantita- tive and qualitative process involving a risk and investment return analysis. A 596 Making Key Strategic Decisions complete valuation is more than simply analyzing the historic financial state- ments of the business and then making future projections. Valuations that give the most accurate results consider qualitative matters such as technology changes, the company’s competition, and its customers. In addition, other areas that are considered are macro-environment issues such as the industry and the national and local economic factors that affect the particular business. A com- plete business valuation will consider the following areas: • Analysis of the company. • Industry analysis. • Economic analysis. • Analysis of the company’s financial statements. • Application of the appropriate valuation methodologies. • Application of any appropriate valuation discounts or premiums. A large part of valuing a business is the assessment of the investment risk of buying and owning the business. A buyer of the business assumes the risk that he or she will actually receive the anticipated economic benefits. Of course, there is no guarantee of actually receiving the projected income. A fundamental concept in business valuation is the risk-reward relationship in making any kind of investment. Rational individuals and companies make in- vestment decisions regularly by comparing the risk of an investment to the anticipated rewards. For example, a certificate of deposit from a bank that is guaranteed from default may have a rate of return (interest) of 5%. This in- vestment has little or no risk. Investments in large public company (large-cap) stocks have traditionally returned an average of 10% to 12% per year over the long term. Small public company (small-cap) stocks have average historical rates of return in the 15% to 20% range over the long term. These three types of investments illustrate the risk-reward relationship investors have in making decisions. Buying large-cap stocks instead of a certificate of deposit carries more risk and, thus, the market rewards the investor with a higher rate of re- turn. Small-cap stocks over the long term have been more risky than large company stocks and have rewarded investors even more with higher returns. Simplistically, the valuation of a closely held business considers the risk of an investment in the company and compares it to alternative forms of investments. Victoria further explains that valuation concepts are founded in several economic principles. The first is the principle of alternatives that states that each person has alternatives to completing a particular transaction. In the pre- ceding example, the individual has the alternatives of investing funds in a bank certificate of deposit, large-cap stocks, or small-cap stocks. Investing in a busi- ness is yet another alternative. The second economic principle in valuation is the principle of substitution. This states that the value of something tends to be determined by the cost of acquiring an equally desirable substitute. For ex- ample, if a new restaurant offers steak on its menu, it will likely have a price similar to other restaurants selling steak (all things being equal). The first Business Valuation 597 restaurant will probably not sell very many steaks if the price is double what the customer could buy at another restaurant. Likewise, a potential purchaser of a business is not likely to pay significantly more than the price he or she can purchase a similar business. In business valuation, we must remember that buyers/investors have many places to invest their money and they will generally not pay significantly more for a business than the price of comparable investments. Thus, a business valu- ation will generally benchmark the profitable private company against alterna- tive investments. This involves an analysis of the risk of those investments as well as those of the business being valued. INDUSTRY ANALYSIS ACME operates in the adhesive and sealant industry. The U.S. government’s Standard Industrial Classification (SIC) is number 2891. Victoria researches this industry and finds that the segment consists of approximately 1,100 U.S. estab- lishments primarily engaged in manufacturing industrial and household adhe- sives, glues, caulking compounds, sealants, and linoleum, tile, and rubber cements. The annual sales in this industry segment are $16.9 billion, and the in- dustry employs roughly 36,000 people. Also, the industry has grown at an aver- age annual compound rate of 6.7% over the past 10 years. Victoria finds that this industry segment is a large growing global segment. However, the U.S. portion is highly fragmented and a significant majority of the industry participants are small and regional companies. It is expected that the industry will consolidate as companies seek to enhance operating efficiencies and new product development, sales and marketing, distribution, production, and administrative overhead. Victoria concludes that the industry outlook is positive in revenue and earnings expectations but moderated by the level of competition from numer- ous, smaller companies selling similar products. THE FUNDAMENTAL POSITION OF THE COMPANY During Victoria’s management interview, she discovers that Bob founded ACME 20 years ago. The company’s history has been one of relative success. It started in a small garage and grew by expanding the number of products and its customer base. Over the years, ACME acquired new facilities, not only in its hometown but in other cities as well. The company’s growth was primarily funded by reinvesting its profits and with long-term financing when purchasing real estate. During the past five years, ACME’s sales increased from $34 mil- lion to $50 million. ACME currently expects to expand its manufacturing ca- pacity by adding equipment to the existing locations. Victoria’s investigation into ACME’s competitors reveals competition from numerous companies, many of which are small, privately held businesses. 598 Making Key Strategic Decisions She also finds that ACME’s customers are retail distributors of its prod- ucts and the company does not have any significant customer concentration. Generally, relationships with customers have been long term. The company currently has numerous products in the adhesives and sealants area. ACME has several trademarks and several products that are well recognized as well as ACME’s name. Victoria determines through her research that the risk of product obsolescence or replacements by new products is a minimal risk to ACME. ACME has conducted research and development activities and the costs range from $250,000 to $500,000 per year over the past five years. Manage- ment does not expect any significant product developments in the near future. Victoria’s financial analysis examines the dividend paying capacity of ACME. Because the company is closely held, special analysis of the compensa- tion paid to family members and perquisites is necessary. Victoria determines that officers’ compensation, shareholder distributions, and perquisites over the past five years have been as follows: Officers’ Compensation, Perquisites, and Shareholder Distributions Year $ Million 2000 $7.7 1999 5.5 1998 8.2 1997 6.3 1996 6.5 Closely held businesses are frequently operated to minimize taxable in- come. Publicly held companies, in contrast, are operated to maximize earnings for the benefit of the shareholders and public markets. A financial analysis of a closely held company should make adjustments so that revenues and expenses are “normalized.” In this particular case, Victoria determines the amount of economic benefits the family members took from the business and compares that with the market compensation for others employed in similar positions. The difference between the two amounts is actually an economic benefit or dividend (profit) flowing to ACME’s owner. Victoria’s analysis strives to iden- tify the actual profitability of the business enterprise even though it is differ- ent from what is reported on the income statement. ACME has approximately 240 employees at its six locations. The three top individuals in management are family members including Bob. Should the company be sold, it is unlikely that the three family members would remain in the business. Summary of Positive and Negative Fundamental Factors As a result of Victoria’s preceding analysis of ACME’s fundamental position, she identifies the following key positive and negative factors for the company. Business Valuation 599 Positive ACME has been in existence for 20 years. ACME has a long-term history of growing sales and profits. ACME owns several trademarks for products that are well known. ACME has diversification in the number of its manufacturing locations. ACME’s industry outlook is moderately positive. The demand for ACME’s products is expected to continue. Negative ACME is highly dependent on the three family members who hold the top management positions. ACME’s products face significant competition and are regionalized. FINANCIAL STATEMENT ANALYSIS An analysis of a company’s historic financial statements is important (unless it is a start-up business), as the past is usually relevant to estimating future busi- ness operations. If a company has had high growth in recent years, that may in- dicate significant growth potential in the future. If past earnings have been volatile, this is an indication of increased financial risk for a buyer of the busi- ness. While an analysis of the financial statements is important, the process does not stop with looking at the company’s past performance. The ultimate goal of the quantitative analysis is estimating the future profitability of the business since that is what a prospective buyer is looking to receive. Future earnings may or may not be similar to the past. Balance Sheet Analysis Victoria prepares Exhibit 18.1 that presents ACME’s historic balance sheets in condensed form for the most recent five years. She finds that total assets grew an average of 15% per year over the five years and a similar amount in the most recent year. The current assets consist primarily of accounts receivable and in- ventory. Fixed assets primarily consist of land, buildings, and improvements, machinery and equipment, factory construction in progress, and transportation equipment. As of the most recent year’s end, ACME’s depreciable fixed assets were depreciated to 69% of their original costs. The most recent year reflects unamortized intangible assets, consisting primarily of goodwill (that had been recorded in accordance with generally accepted accounting principles) in connection with ACME’s acquisition of a manufacturing facility. Current liabilities consist of accounts payable and the amounts due within the next 12 months on promissory notes and obligations under capital leases. ACME is moderately leveraged. During the past five years, ACME’s in- terest bearing debt (both current and noncurrent portions) increased from $6.6 600 EXHIBIT 18.1 ACME Manufacturing Inc.: Summa ry of condensed balance sheets 1996 –2000. ($million) Growth R ates 2000 1999 1998 1997 1996 1996–2000 1999–2000 Assets Current assets $11.69 $11.56 $12.37 $ 9.43 $ 9.17 6.3% 1.1% Fixed assets, net 13.87 10.36 9.37 7.65 6.79 19.5 33.9 Other assets 3.17 3.00 3.25 1.12 0.62 50.4 5.5 Total assets $28.72 $24.92 $24.98 $18.20 $16.58 14.7% 15.3% Liabilities and Equity Current liabilities $11.50 $ 6.41 $ 8.78 $ 4.34 $ 4.94 23.5% 79.4% Long-term liabilities 5.83 7.26 7.78 4.85 4.96 4.1 −19.7 Total liabilities 17.33 13.67 16.56 9.19 9.90 15.0 26.8% Equity 11.39 11.25 8.42 9.01 6.69 14.2 1.3 Total liabilities and equity $28.72 $24.92 $24.98 $18.20 $16.58 14.7% 15.3% Common Size 2000 1999 1998 1997 1996 Assets Current assets 40.7% 46.4% 49.5% 51.8% 55.3% Fixed assets, net 48.3 41.6 37.5 42.0 41.0 Other assets 11.0 12.0 13.0 6.1 3.7 Total assets 100.0% 100.0% 100.0% 100.0% 100.0% Liabilities and Equity Current liabilities 40.1% 25.7% 35.1% 23.9% 29.8% Long-term liabilities 20.3 29.1 31.2 26.6 29.9 Total liabilities 60.3 54.9 66.3 50.5 59.7 Equity 39.7 45.1 33.7 49.5 40.3 Total liabilities and equity 100.0% 100.0% 100.0% 100.0% 100.0% Business Valuation 601 million to $10.4 million. Debt consists of real estate mortgage notes, term loans, a revolving line of credit, and obligations under capital leases. Over the past five years, the shareholder equity increased from $6.7 mil- lion to $11.4 million. Shareholder equity decreased slightly as a percentage of total liabilities and equity over the past five years. Income Statement Analysis Victoria also prepares Exhibit 18.2 that presents ACME’s historic income statements in condensed form for the past five years. She also prepares Exhibit 18.3, which is a graph of ACME’s annual revenues for the previous five years. It graphically shows the revenue amounts from Exhibit 18.2 and more clearly shows the revenue growth trend. The company had a compounded annual growth rate in revenues of 11.1% during the previous five years and 3.5% for the most recent year. ACME’s revenue growth rate over the past five years was substantially higher than the 5.6% revenue growth reported by the chemical products industry. Cost of goods sold as a percentage of revenues fluctuated between 66.6% and 69.9% over the past five years. Operating expenses, exclusive of officers’ compensation, ranged from 9.8% to 11.8%. The overall trend is up. ACME reported consistent profitability during the past five years. In 1996, income before officers’ compensation and taxes was $6.5 million ($4.31 + $2.23). For 2000, it increased to $8.7 million ($5.29 + $3.38). Ratio Analysis Victoria also prepares Exhibit 18.4 that presents various financial operating ratios of ACME for the past five years. The liquidity ratios indicate the ability of ACME to meet current obligations as they come due. The current ratio decreased from 1.9 to 1.0 during the five-year period. Working capital also de- creased from $4.2 million to $190,000 during the same five-year period. These indicate the company has a greater risk in being able to pay its bills. The activity ratios indicate how effectively a company is utilizing its as- sets. The average number of days in ACME’s accounts receivable was similar over the past five years at approximately 50 days. However, the average num- ber of days inventory remained at the plant before being sold decreased from 58 days to 47 days. The average number of days of accounts payable was simi- lar during the five-year period at 48 days. The coverage ratios indicate a company’s ability to pay debt service. The number of times interest was earned, as measured by earnings before interest and taxes (EBIT) divided by interest expense, decreased from 8 to 7 times. The leverage ratios generally indicate a company’s vulnerability to busi- ness downturns. Highly leverage firms are more vulnerable to business down- turns than those with lower debt-to-worth positions. ACME’s debt to tangible worth increased in the past five years from 1.5 to 1.8. Fixed assets to tangible worth increased from 1.0 to 1.5. 602 EXHIBIT 18.2 ACME Manufacturing Inc.: Summa ry of condensed income statements 1996 –2000. ($million) Growth R ates 2000 1999 1998 1997 1996 1996–2000 1999–2000 Revenues $50.29 $48.59 $40.85 $37.94 $33.02 11.1% 3.5% Cost of goods sold 34.80 33.95 28.45 25.25 22.63 11.4 2.5 Gross profit 15.49 14.64 12.39 12.69 10.39 10.5 5.7 Operating expenses 5.95 5.58 4.34 3.72 3.31 15.8 6.7 Officers’ compensation 3.38 2.86 3.53 3.03 2.23 11.1 18.4 Operating EBITDA 6.15 6.20 4.52 5.94 4.86 6.0 −0.9 Depreciation and amortization 0.31 0.22 0.10 0.05 0.07 44.9 42.3 Operating income (EBIT) 5.84 5.99 4.42 5.89 4.79 5.1 −2.5 Miscellaneous (income) (0.30) (0.25) (0.19) (0.18) (0.12) 26.1 17.1 Interest expense 0.84 0.74 0.55 0.47 0.59 9.0 12.6 Pretax income 5.29 5.49 4.06 5.60 4.31 5.3 −3.6 Less: Income taxes* — — — — — N/A N/A Net income $ 5.29 $ 5.49 $ 4.06 $ 5.60 $ 4.31 5.3% −3.6% Common Size 2000 1999 1998 1997 1996 Revenues 100.0% 100.0% 100.0% 100.0% 100.0% Cost of goods sold 69.2 69.9 69.6 66.6 68.5 Gross profit 30.8 30.1 30.3 33.4 31.5 Operating expenses 11.8 11.5 10.6 9.8 10.0 Officers’ compensation 6.7 5.9 8.6 8.0 6.8 Operating EBITDA 12.2 12.8 11.1 15.7 14.7 Depreciation and amortization 0.6 0.5 0.2 0.1 0.2 Operating income (EBIT) 11.6 12.3 10.8 15.5 14.5 Miscellaneous (income) −0.6 −0.5 −0.5 −0.5 −0.4 Interest expense 1.7 1.5 1.3 1.2 1.8 Pretax income 10.5 11.3 9.9 14.8 13.1 Less: Income taxes* 0.0 0.0 0.0 0.0 0.0 Net income 10.5% 11.3% 9.9% 14.8% 13.1% * ACME is an S corporation for tax purposes and taxab le income is passed through to the shareholder. Thus, the co rporation does not pay income taxes. [...]... Management of ACME prepared a financial projection and discusses it and the underlying assumptions with Victoria Management’s financial projections are presented in Exhibits 18. 5, 18. 6, and 18. 7 Key assumptions incorporated into the projections include: • Sales would grow 12% in 2001 and 2002, 11% in 2003 and 2004, and 10% in 2005 • Costs of goods sold are 69% of sales • Operating expenses (exclusive of... hour of sound Changes in accounting estimates: Estimates are essential to the implementation of accrual accounting A typical example would the estimates of useful lives and salvage values that are necessary in computing depreciation Changes in either useful lives or salvage values would represent changes in accounting estimates Changes in accounting principles: A change in the accounting treatment applied... of accounting The most common examples would be discretionary changes in inventory and depreciation accounting A firm might change from the LIFO to the FIFO inventory method or from the accelerated to straightline method of computing depreciation Most accounting changes are not discretionary but rather are the result of the mandatory adoption of new accounting standards Charges: Commonly used in accounting. .. Manufacturing Inc.: Projected invested capital net cash f lows 2001–2005 ($million) 2001 Projected after-tax income Projected interest expense Tax shield of interest expense Common stock dividend adjustment Projected depreciation/amortization After-tax gross cash f low to invested capital ± Increase/decrease in working capital (excluding interest-bearing ST debt) ± Increase/decrease in investments ± Increase/decrease... are not They include the following: • Decrease expenses (increases cash f low/income) • Increase revenues (increases cash f low/income) • Significantly increase the earnings growth rate (may increase earnings projections, lower capitalization rate due to growth factor) • Eliminate the owners’ personal expenses and perquisites (increases cash f low/ income, lowers buyer risk of inaccurate financial statements)... conduct a business valuation that is not overly complex, the question remains whether the resulting value is accurate Many variables go into a valuation analysis A business valuation is both a quantitative and qualitative process that is focused on assessing investment risk and investment return It is largely an assessment of the risks a buyer is taking in acquiring and owning the company In addition,... accounting: An accounting method that recognizes revenues as they are earned and expenses as they are incurred The timing of revenue and expense recognition is not tied to the timing of the inf low and outf low of cash Accrual accounting is seen as essential in order to develop reliable measures of periodic financial performance Acquisition: The purchase—not necessarily for cash—of a controlling interest... to him Therefore, his minority interest is less marketable Intuitively, investors prefer owning marketable investments over nonmarketable ones Therefore, buyers of minority interests in private companies typically pay less since the shares are not marketable This is called a discount for lack of marketability In valuing a minority interest, a major consideration is the timing and amount of the anticipated... The owner of a minority interest in most private businesses cannot control the company A control interest in a company has the power to direct management and policies of a business usually through ownership of enough shares to inf luence voting and other decisions Intuitively, someone would rather own a control interest in a private business (51%) instead of a minority interest (49%) because of the power... debt capital is 5.4% (9% interest cost less 40% in reduced taxes) For every $100 ACME pays in interest expense to the bank, its income tax obligation is lowered by $40 because interest is a business expense that lowers taxable income Thus, ACME’s after-tax interest expense is $60 ($100 minus $40 in reduced taxes) In order for a business to raise equity capital (selling stock to investors), it expects . a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and. actually receiving the projected income. A fundamental concept in business valuation is the risk-reward relationship in making any kind of investment. Rational individuals and companies make in- vestment. discusses it and the underlying assumptions with Victoria. Management’s financial projections are presented in Exhibits 18. 5, 18. 6, and 18. 7. Key assumptions incorporated into the projections include: •