There is no asset that appears to confound advisors more than ownership in a business enterprise; perhaps, more so, a partial interest in a business or real property. The sheer number and impact of legal and financial issues has a myriad of implications on value. It is human nature to steer clear or minimize the net result of these issues, as they can be daunting. However, in the absence of substantial and independent conclusions that are empirically supported, opinions of value are mere guesses. Such estimates can lead to egregious losses of thousands, if not millions of dollars for your clients. A working relationship with a seasoned business valuation analyst (appraiser) can secure your advisory role with clients who require your advice in areas ranging from estate and succession planning to enhancing value via a thorough review of current operations.
Business appraisal and economic damages analysis is a niche. The CPA credential, in of itself, is unlikely to provide the requisite skills and resources to render opinions of value and may pose some conflicts of interest as well. Even after performing well over 350 written business valuation and damage assessment reports; holding membership and/or accreditation in all of the national business valuation organizations and providing testimony in over 100 epositions and court, there is much to learn about this industry. This chapter will provide insights to many of the issues confronting the business valuation analyst in the context of estate related work.
Thinking like an investor
Regardless of the property held, the business appraiser’s role may be simplified by attempting to simulate and quantify the most likely decisions made by a pool of investors. Obviously, marketable securities of publicly traded companies represent highly liquid, minority interests that can be bought and sold in minutes with cash changing hands in a matter of days. An investor principally examines several factors, but inevitably is concerned with the degree of risk compared to the economic benefit or return. Returns may be achieved by growth (capital appreciation), income (distribution of dividends) or both. The greater the likelihood that growth and income will be achieved, the lower the risk. The lower the risk, the higher the value of the property and the investment expected to acquire it. In simple terms, how much cash can be readily and consistently received during what time frames? This is basic financial theory where the property owner has to be aware of the market and economic climate for the specific investment as well as others, which may offer less risk or higher returns.
The second issue is one concerning holding period and liquidity. If the asset cannot be readily sold due to the impairment of having a limited pool of buyers, then the holder of an interest in this property may not be readily able to achieve a “cash equivalent” value as of a specific date when (s)he wishes to sell without adjusting price sufficiently to attract a buyer. Therefore, the adjustment or “discount” becomes more profound in cases where the interest held generates little or no income or when the investor has little or no control over the performance and subsequent sale of the asset.
This is certainly the case when one holds an undivided 10% interest in raw land, which may have appreciated in value, but the interest holder is unable to find a buyer without the consent of the majority of other interest holders. The absence of the legal “bundle of rights” places restrictions on liquidation, sale or transfer, which, in turn, emphasizes why the 10% interest is not simply worth one-tenth of the pro rata value of the entire property held. These concepts are the underpinning thoughts that lead to the establishment of Trusts, Tenancy-in-Common, LP/LLCs and subsequent gifts of partial interests in everything ranging to an operating manufacturer to an LP holding marketable securities and income producing real estate.
Volumes could be written as to what constitutes an acceptable level of work product that would pass the Daubert challenge, if litigated. While not all inclusive, this brief article strives to highlight some of the most basic aspects.
Nature and history of the business: The year formed and a cursory
examination of financial summary is hardly adequate. Past transfers, examination of provisions in by laws, agreements, articles, legal documents and the impact of management’s skill, education, depth and health are several areas that should be commented upon whether the entity is an operating or asset holding company.
Economic and Industry Outlook: Businesses do not operate in a vacuum. In today’s economy capital for purchasing equity or debt to finance growth is difficult to come by even by banks and publicly traded companies. This has had a significant downward influence on most companies’ values. Tighter capital tends to reduce growth and curtail profitability. Some industries are prone to being impacted more than others. If the restaurant your used to making reservations 2-months now accepts walk-ins, rest-assured its value has likely declined. Averaging the past several years’ performance is counter-intuitive in this case. Think of a publicly traded company’s stock price after market analysts recommend
a “SELL” from a “HOLD” position. The stock price is likely to take a 5% or 10% “haircut” (value reduction) based on current events, not solely historic.
Book value of the stock and business’ financial condition: Understand that the more the business relies upon tying up money in equipment, real property and inventory, the more likely the value will be more proximate to its book value. Conversely, a company with significant intellectual property and/or reputation, such as a service or technology business, will have most of its value associated with intangible assets, which will seldom be reflected on the company’s balancer sheet. The reliance on debt is favorable up to an optimal period; however, the higher the debt above this amount the greater the risk of insolvency. If there’s nominal discussion about these factors and the profitability and liquidity of the entity compared to external industry comparative data, then it’s inadequate.
Earning and Dividend-paying Capacity: Simply put, has there been a
history of distributions and at what level and frequency. If the company is
holding onto excess cash and investments beyond what it needs to grow the company (working capital needs); then these values would be stripped out and added back after the value of the operating company is determined. Management should have an understanding of cyclical issues, such as seasonality or varying costs of materials that allows it to hold what is needed with a reasonable cushion. Looking at officers’ compensation may also indicate, over- or under-compensation. These issues require the analyst to look at many line items on the financial statement, such as occupancy and labor to ensure they’re not influenced by related-party expenditures.
Existence of intangible assets: If every building and piece of equipment were destroyed and every employee of Coca-Cola called in sick is there any doubt that the brand trademark and the patent for Coke’s recipe would be worth billions of dollars. The same issues hold true to relationships, time and resources invested in research and intellectual property that may or may not be generating royalty fee income. Professional practices and sole and separate property as well as passive and active efforts have significant implications, whose values cannot be adequately determined in the absence of human determination of an expert, not a software programmer.
Sales of stock and block size: Often prior stock transactional history, if at arm’s length and at the appropriate standard of value, provides as good, if not a better benchmark, of a non-duress arms’ length transaction. The premium or the impairment (discount) for control, voting ghts/governance as well as the repurchase liability (liquidity) influence adjustments to value. The size and rights of a 2% interest may be considerable if there are two 49% shareholders (2% + 49% = 51%) and provisions call for a majority over 50%. This would differ from fifty 2% shareholders. The analyst must also be clear that s/he is valuing equity and not the enterprise. Equity value is commonly the enterprise value less all interest-bearing debt.
Market price of traded stock of same or similar companies in a same or similar industry: Because the availability of data is relatively thin for closely held businesses, the transactional data must be closely evaluated to determine whether it provides a reasonable (not exact) proxy of the equity being valued. When there are aspects of the transaction, such as if it was all cash or (un)favorable financing, time frame, duration of listing, the cyclical nature of the industry making multiples of earnings or revenues more challenging to isolate, it is imperative that these issues are described and addressed.
Bottom line is there are cookbook valuations following a formulaic process that can be woefully inadequate; especially, when a software program is doing most of the calculating. One might liken it to commoditizing the legal professions’ services by inputting the type of matter, dates, and the issues/needs with a range of possible outcomes as the output. I’m sure my litigation, estate planning and business law clients might be horrified by such a preposterous suggestion. Welcome to our world!
“The Small Business Economy for Data Year 2005, A Report to the President”, released December 2006, states businesses with fewer than 500 employees account for 99.7% of all employer firms in the U.S. Very small businesses (with fewer than 20 employees) are responsible for half of the country’s nonfarm real gross domestic product. More interestingly, many of these businesses will struggle in achieving liquidity after the founder contemplates an exit. A good number of these business owners will face disruptive influences, such as a dispute with a partner or spouse.
The best financial expert sees both sides of the coin when addressing the complexities of intangible values incident to allocating goodwill; especially when a marital or partner dispute is involved. This article addresses the vulnerability of bias favoring the business owner often resulting in understating value(s). This article addresses the legitimate motivation of the owner as an active investor striving to enhance both his management efficiencies and technical knowledge to garner and secure market share while enhancing equity value. It also addresses the inescapable topics of double dipping and reasonableness of officer/owner compensation versus the distribution of profits and reinvestment in the business.
Brian Brinig, JD, CPA, ASA (Brinig & Co., San Diego), has argued that recasting/ normalizing officer’s [owner’s] compensation should not be referred to as a ‘reasonable [or replacement] compensation’ adjustment1. “Instead, the more appropriate term is a fair value of the owner’s services adjustment…from the perspective of a hypothetical investor.” This appears to align with the argument of portability or the probability of transferability of the knowledge and management skills of the owner. Certainly, some business owners and professionals with the ability to pay fees, often $20,000 or greater, might wish to retain an expert arguing nominal enterprise value due to substantiated high professional or officer/owner compensation.
Yet, this gives rise to two issues: The perspective of the investor and the anticipated economic “benefit” from returns on capital assets (dividends/income) versus labor/knowledge (wages). Private equity investors gravitate to one of two schools of thought. Value are in business assets and assumes leverage of the equity firm’s management team’s knowledge to increase business investment performance. The other sees primary value derived from existing company’s management’s skills that create value in the assemblage of underlying assets.
The second issue of economic benefit stems from value growth through reinvesting in the company versus taking most profits or a balance of both. What portion of profits should be attributed to what the owner earns as management compensation (base salary plus short- and long-term incentives) and what should the owner receive as an investment return or distribution is a significant analyst challenge.
After earnings adjustments are made, it is this figure that is considered as a proxy of the future earnings’ stream and is capitalized (risk/rate divisor as a percentage) in order to determine entrprise value that is assumed to eventually materialize.
Tax implications are often a driver in this issue. Reasonable compensation is often reflected as what the market reflects a person could expect to receive to perform a function with consideration of market conditions and individual talents. It’s understandable how these two items derived from the same source of economic benefit can lead to “double dipping” in divorce situations: That of support payments and allocation of a company’s intangible asset value(s) as opined by Robert J. Rivers, Esq., a Boston attorney2.
Enter Mr. Brinig, who opines “If there is no ‘thing,’ separate from the professional that generates the income stream… If the goodwill of the business is not saleable, that’s a big red flag… You’ve got to have an asset to value.” (Intangible value is the difference between the value of a business and its tangible assets, such as cash, inventory, equipment, accounts receivable, etc. The more service-oriented and/ or knowledge-based a business is, the greater likelihood the majority of its value will be intangible and the more difficult it will be to isolate the source of income.)
The term “goodwill” can be inadvertently comingled with all intangible assets, which may result in the undervaluation of business’ interest(s). This belief may not fully recognize that intangible assets have shelf-lives whereby the speed and duration in which value is measured differs and that to the extent an asset is difficult to isolate does not mean it doesn’t exist.
The underlying issue could be construed as, can an under- or non-performing asset exist (and have no readily perceived value), if there is no direct income generated at a discrete point in time? Consider the example of organizational improvement by enhancing personnel and processes. It may have a delayed economic outcome that inevitably causes greater patronage, revenues and profits, but with many moving parts of a company, the direct source(s) and values may be masked. Is this an active or passive income asset? Does passive mean non-existence? The same concept applies to patents, trademarks and copyrights; regardless, if income is presently derived.
Few business owners would suggest their companies solely have walk-away value. Further, they have an implied fiduciary duty to maximize the economic benefit and reduce risk to achieve the highest level of return on all assets held in a business while legally minimizing the impact of taxes on profits and transfers.
This would imply there is a willingness to regularly put forth the necessary efforts to ensure capital appreciation (growth) and enhance profits. Therefore, increased personal knowledge, such as more efficient use of time, may increase company earnings as well as the officer’s compensation. Although, the later result is not always the case, as the owner may wish to reinvest in company growth versus receiving higher immediate officer compensation. These attributes reflect similar ones expected of active asset managers versus passive investors.
So, from a seller’s perspective owners/sellers are likely to actively assist in the gradual transfer of ‘assets,’ such as business relationships, to new buyers seeking the highest price. Buyers may require an “earn out” provision in a sale to offset lost value from relationships that are unsuccessfully retained.
Therefore, the investor, regardless of buyer or seller, will identify which assets create what economic benefits, in what quantity and duration of time. One may surmise that if a non-compete agreement was required incident to a sale, then the personal attributes and knowledge of the seller hold value in a given market for a given time aside from the seller’s personal earning capacity/history.
Understandably, the more compensation allocated towards individual productivity and specialized skill, the lower the allocation that can be made for value creation towards the business entity in the absence of an understanding that this body of knowledge can and will be transferred.
What’s clear is (1) that there may be more than one valuation standard and approach that adequately captures the above time-value factors considered by arm’s length investors with certain return expectations and (2) that allocation of assets and economic benefit is a necessary, albeit not always precise, requirement. Also, the manner in which external (ex. market penetration and consumer confidence) and internal factors (ex. management depth/skill and debt/equity levels) influence value cannot be easily dismissed. Finally, simply because one party in a legal dispute lacks the liquidity to purchase an ownership interest does not mean value is absent, but rather a structured deal is needed.
1) The Eighth Circuit Court provided nine criteria for evaluating compensation. The criteria, virtually all aimed at current activity, were: The employee’s qualifications; The nature, extent and scope of the employee’s work; The size and complexities of the business; The prevailing general economic conditions; The prevailing rates of compensation for comparable positions in comparable concerns; The salary policy of the taxpayer as to all employees; In the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years; A comparison of salaries paid with the gross income and net income; and A comparison of salaries with distributions to stockholders. Arguably, Dugan v. Dugan also includes Age, Experience, Education, Expertise, Effort, and Locale. In Lopez v. Lopez, a California appellate court’s decision identified several factors that valuators should consider before expressing an opinion including: age and health; demonstrated past earning power; reputation in the community for judgment, skill and knowledge; and comparative professional success.
2) “The concept of double-dipping refers to the double counting of a marital asset, once in the property division and again in the support award. This theory is premised upon the fact that the same cash flows capitalized to determine the present overall value of a spouse’s business (an asset subject to marital distribution) are also considered a component of that spouse’s total income for support calculation purposes. More specifically in the context of divorce proceedings, where the court uses a business owner’s “excess earnings” to value the business and also fixes support based upon that spouse’s total income (inclusive of the excess earnings used to value the business), a double-dip can occur. In order to fully understand the double-dip issue, an understanding of basic business valuation theory and methodology is required.”
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