23July

Online Business Valuation

The BizEquity Solution

By Scott Gabehart, Certified Business Appraiser and Vice-President of Valuation Support and Services for BizEquity

The recent article by Mark Cohen in the New York Times titled “Do You Know What Your Business is Worth? You Should” contained a number of relevant insights related to the valuation of privately-held companies – including the “commanding” title itself.  Interestingly, the first part of this title happens to be our primary tagline at www.bizequity.com.

Singlemost Important Piece of Advice

Cutting to the chase, my analysis led to the conclusion that the primary or singlemost important sentence in the piece was:

     “….it helps to have at least a basic understanding of the valuation process.”

The implication was, it seems that many business owners do NOT have a basic understanding of the valuation process.

Enter BizEquity

Pioneered by experienced entrepreneurs and valuation experts alike, there is now a tool available which can help the business owner to “Optimize, Optimize, Optimize” as Mr. Cohen puts it convincingly in his final comments.  Importantly, the employees of BizEquity are devoted to the development and implementation of a comprehensive suite of business valuation methods which will allow the user to generate a credible, reliable and accurate estimate of fair market value on a going concern basis – from the perspective of both an “asset sale” and “stock sale” paradigm.

Why Do Online Tools Disappoint?

There are several online valuation tools or calculators which can be located via the internet which run the gamut from extremely basic calculators with 3 or 4 entries to complex discounted cash flow applications based on Excel spreadsheets and the Capital Asset Pricing Model  complete with “beta” and a staggering number of assumptions stemming from modern portfolio theory.  Neither of these options can truly help the typical small business owner determine value or understand what truly determines business value.

The primary reason why a business broker (such as Barbara Taylor in the Cohen article) using many of the current online tools (calculators are a better description in many cases) would be disappointed in the valuation estimate is their inability to properly gauge cash flows for valuation purposes (whether in the form of “discretionary earnings” or “net cash flows” or “after-tax profits”).  Even those tools which fall in between the two extremes just identified are unlikely to “hit the mark” for this key metric.

Unless the valuation algorithm specifically addresses owner or officer compensation in a robust manner, the results will be more than disappointing. More specifically, the earnings stream most suitable for a small company is reflective of a “return on the owner’s labor” as opposed to a “return on investment” perspective.  Most specifically, it must reflect the “pretax, cash equivalent financial benefits available to a single owner working on a full-time basis” in order to pass “the smell test”. 

Such a tool must also be able to account for other “outliers” so to speak, ranging from a variety of non-recurring or non-operating expenses/revenues to the imputation of a market level rent burden if the subject company happens to own the underlying real estate. Without these adjustments, valuation results based on pretax profits or an unadjusted EBITDA will almost always fall short of what would be deemed a “credible” estimate.  Contingent liabilities and net operating loss carryforwards are examples of balance sheet adjustments which must be captured in order to derive a credible estimate of “equity value”.

Through literally years of trial and error, BizEquity has managed to work all of these key valuation elements into their algorithm. By accurately determining the proper earnings/cash flow amount, other key value determinants can be utilized to build the proper valuation multiple or capitalization/discount rate.  Factors such as size, expected growth and profit margins, customer concentration, importance of owner-operator to business performance along with other financial statement ratios can be used to assess areas such as liquidity, solvency and activity as compared to industry benchmarks.

Second Most Important Piece of Advice

The second most important piece of advice from Mr. Cohen’s article, in my opinion, reads as follows:

     “But some are starting to treat the act of valuing their business as an integral part of running it.”

Naturally, treating the valuation process as part of day to day and strategic planning requires the “basic level of understanding” referred to earlier.  BizEquity wants to do more than just provide a bottom line number.  The unique and patented user interface allows the user to visually note how a changing variable can impact the final estimate of value – in real time. 

In addition, the firm is in the process of publishing a series of blogs which, from start to finish, will educate the owner on key concepts related to business valuation.  These blogs will, in part, be incorporated into a new book that Mr. Gabehart and Mr. Carter are currently writing called “Valuation 2.0”.  This unique book will be the formal link between the business owner and their quest for knowledge in the valuation realm. Beyond providing a user-friendly overview of the business valuation process, this book will also give the readers added insight into how to use the online tool – both in general and with respect to maximizing business value over the long run.

Final Comments

As noted by Mr. Cohen, it is certainly true that small business owners are, almost without exception, extremely preoccupied with “the day-to -day demands” of their companies.  And yes, there are many instances when there is “something to be said for having a real person trained at valuations”.  As I have duly noted in my blogs, it is clearly the case that “there’s an art to doing a valuation.”  Finally, I have no doubt that there are many online tools which would produce different results from what a hands-on and experienced business broker would surmise as being the correct value.  Even “reasonable” professional appraisers would admit that a given company’s value can easily range up or down by 10% to 15% around some hypothetical average or probable value.

Despite these admissions, I have seen firsthand that we can assist business owners with efficiently (but steadily) learning about business valuation and how it relates to both their day to day operations and long term planning. After four years and literally millions of dollars in invested capital by the former credit card giant Advanta and now the new owner Mr. Michael Carter, we have introduced an “online tool” which we hope will become more of a “way of thinking” than a once in a while application.  Our forthcoming book will deal with this in detail as we delineate the finer points of what we term “Enterprise Value Management”. In short, all roads lead to “value”. 

Based on my experience as an internal auditor, business broker/middle market specialist, real estate agent, securities agent and certified business appraiser, I have spent most of the past two decades immersed between buyers and sellers of privately-held businesses of all types and sizes.  Along the way, I have written two major books (covering business brokerage and business valuation) and developed/taught an MBA level course on private firm valuation for the highest ranked international MBA program in the entire country.  All of this experience is being incorporated into the development of BizEquity with the ultimate goal of teaching business owners how to value their most precious assets – and how to “optimize” this value.

Start Your Business Valuation!

Posted in New Developments

23July

Business Valuation Rules of Thumb

Do They Matter?

By Scott Gabehart, Certified Business Appraiser and Vice-President of Valuation Support and Services for BizEquity

thumbDespite a great deal of dismissal on the part of “sophisticated appraisers”, the reality is that these so-called rules of thumb frequently drive the valuation dynamic of smaller, owner-operated businesses. To the extent that such a rule optimally “mimics the marketplace”, such an outright dismissal is in the valuator’s opinion bordering on negligence. Certain seasoned intermediaries are convinced that the “market databases” are generally nothing more than the recorded evidence of how rules of thumb are used to buy and sell such entities.

The author recognizes and admits that certain unique business types or larger, middle-market sized enterprises will not be “optimally” valued by way of such rules – rather these rules should serve as more of a “sanity check” or “cross-check”.  Ideally, rules of thumb will be used in tandem with other valuation methodologies which best fit the given assignment – but ignoring them altogether can be a major error in many cases.  Rules of thumb are generally considered to be part of the market approach to business valuation. 

If it is known with certainty that the buyers and sellers within a given “market for business control” utilize a specific rule of thumb (or multiple rules) to reach a mutually agreeable purchase price, avoidance of such rules would be highly problematic (especially when the goal is to estimate the “fair market value”).

In general, the use of rules of thumb typically revolves around the following components:

  1. Gross Revenue Multipliers (monthly, annually)
  2. Earnings Multipliers, e.g. ACF, EBITDA, EBIT, Pretax Income, etc.
  3. Asset-Based Rule of Thumb
  4. Hybrid Rules (earnings and assets)
  5. Other Multipliers, e.g. number of agents in a real estate brokerage, number of lanes in a bowling alley, etc.

Having performed several hundred business valuations for SBA loan purposes (most of which are small, owner-operated enterprises), I have witnessed firsthand how it is that many rules of thumb play the primary if not sole role in determining business value for purposes of planned transactions between independent parties (in other words, fair market value). The required business appraisal will be based on “generally accepted business valuation principles and procedures” that go far beyond basic rules of thumb, but it is not surprising to learn how often these rules have produced supportable, justifiable and credible estimates of “fair market value”.

One thoughtful business appraiser has written extensively on why it is that rules of thumb deserve the full force of a legitimate standalone business valuation methodology is Mr. Michael Elmaleh (CPA, CVA). He also recognizes the relevance of what we at BizEquity refer to as the “return on owner’s labor” paradigm by introducing a “compensation-based” method of valuing small businesses. 

In short, enlightened appraisers recognize that sole reliance on methods that revolve around “modern portfolio theory” and the Capital Asset Pricing Model (modified or otherwise) is so far removed from the elements which underscore smaller, privately-held and owner-operated businesses as to be “whimsical”. Nonetheless, this perspective prevails among the majority of appraisers today who try diligently to “fit a square peg into a round hole”.  

Mr. Elmaleh’s most recent article titled “The Persistence of Rules of Thumb” (ASA Journal, 2010) is a well thought out analysis of how the use of such rules has not persisted due to their “simplicity” but rather due to their superior capability of capturing the underlying economics of a given business transfer. The rules of thumb have “staying power” because they become “self-reinforcing anchors and standards of fairness” that buyers and sellers both accept as legitimate and helpful in negotiating a given deal.

The “bottom line” it seems is that appraisers are most often hired to value the business based on what it is worth on the open market and not based on what the appraiser believes is an appropriate value. This was the topic of the editor’s column in the 3rd Quarter 2008 edition of the Business Appraisal Practice journal written by Mr. Paul Hyde (EA, MCBA, BVAL, ASA, MAI). As noted in his summary section of the column:

“I suggest that all appraisers constantly remember that it is our job to report what the market actually is instead of what we may think the market should be.”

In many cases – but certainly not always, there can be no better proxy for what current market values are than widely utilized, industry-specific rules of thumb which are properly and cautiously applied.  Having utilized rules of thumb for many years now, I have also been able to identify the fluidity of such “rules”, i.e. they change as macroeconomic and industry fundamentals change (as they should).  As new industries are created, new rules of thumb follow. Internet service providers are a relatively recent phenomenon, but rules quickly emerged for use by interested parties.

Today we focus on rules of thumb for service companies. The great majority are based upon multiples of discretionary earnings or adjusted cash flow (ACF) or multiples of annual revenues (AR). Some rules are seemingly irrelevant and others may include real estate value. As a business broker, I was involved with the listing and/or sale of dozens of accounting/tax practices that were valued almost exclusively via a revenue-based rule of thumb, i.e. by multiplying the anticipated AR by between .9 and 1.2 (90% and 120%).  Science turns to art when an attempt is made to choose between a lower multiple and a higher multiple. 

In practice, accounting/tax firm multiples are influenced by the following:

  • FMV of tangible assets
  • Degree of monthly write-up versus seasonal tax work
  • Average billings/hour
  • Growth in accounts and revenues
  • Profits/ACF relative to AR

A practice with ample, state of the art technology and a preponderance of high paying monthly accounts billed at above average rates in a rapidly growing practice with substantial and diversified (tax versus write-up work) cash flow will generate higher multiples. A shoddy office with only tax work billed at low rates generating declining revenues and minimal cash flow will attract low multiples. However, the majority of practices will sell for about one times gross earnings. Every business type possesses its own unique characteristics that drive the multiples.

The typical accounting/tax deal is financed through a down payment of 30%-50% with the balance paid over 1-3 years subject to an "earnout". If the actual sales revenue for the new accountant are less than the agreed upon anticipated AR, the final selling price will be adjusted downward through the seller's note. In effect, the seller guarantees a certain sales level. It is rare for profitable businesses of any other type to be sold with a guarantee regarding sales, profits or cash flow. Typically only marginal, unprofitable companies will be sold with a revenue guarantee in order to attract buyer interest (or rapidly growing companies requiring compensation reflecting the future growth).

Realizing that other factors like down payment, payback terms (interest rate, number of years, collateral, personal guarantee), stock versus asset purchase, training period, FMV of included assets, covenant not to compete and the size of the company's cash flow can impact the final price for a business, even the application of seemingly simple rules of thumb requires great caution and preferably years of skill and experience.  Franchised businesses can sell for lower or higher than average multiples depending on the relative success of the given franchise system and name. Businesses located in major metro areas will sell for higher multiples than those in less populated rural areas. And so on…

An empirical relationship exists between the amount of ACF and the relevant multiples (called “the size effect”. For example, a business with $50K in ACF may sell for 1-3 times cash flow and a business with $500K in ACF will sell for between 3-6 times cash flow and a business with $5 million in cash flow may sell for between 6-10 times cash flow (all other things equal).

The rules presented below are a representative sample for service businesses and apply to the smaller end of company size with AR up to $1 or $2 million and ACF of up to $200K to $300K.

Service Business Rules of Thumb

  1. Advertising Agency 50% to 75% of AR, may require earnout
  2. Collection Agency 6 to 10 times MR
  3. Construction 4-6 times EBIT
  4. Day Care/Child Care 1 to 3 times ACF or $1K-$2K per enrolled child (more for established and reputable franchises)
  5. Dental Practice 60%-80% of AR (includes inventory)
  6. Dry Cleaners 2-3 times ACF or 70%-90% of AR
  7. Home Health3 to 5 times ACF
  8. Landscaping 30%-50% of AR or 1-2 times ACF
  9. Medical Practice 25% to 50% of AR (larger practice, higher multiple)
  10. Pest Control 70%-120% of AR or 3 to 4 times ACF
  11. Property Management 6 to 8 times MR
  12. Publisher 3-6 times EBIT or 70% of AR
  13. Real Estate Brokerage 30% to 40% of gross commissions or 1 to 3 times ACF
  14. Restaurant/Cafe/Coffee Shop 30%-55% of AR

It is critical to stress that a company's cash flow is ultimately the most important factor impacting business value. Firm specific characteristics also can materially impact valuation results.  Readers interested in obtaining the most current and informative source of rule of thumb data and perspectives should consider buying the 2013 Business Reference Guide through Business Valuation Resources ( http://www.bvresources.com). This is often referred to as “The Business Broker’s Bible” and it has grown in size and utility during the past 20 years or so.

Start Your Business Valuation!

Posted in New Developments

23July

Summit Business Valuator

What's Your Business Worth?

Summit Business ValuatorThere are a dozen reasons why every business should know its value.

Up until now, the task has been expensive and time-consuming but with the Summit Business Valuator the problem is solved. You can perform this function privately and get an instantaneous report.

The report will provide you with estimates which reflect both the “sale of assets” and “the sale of equity” (on a going concern basis) as well as estimates which reflect the liquidation value and the so-called “enterprise value” of your company.

The four conclusions of value provided are as follows:

  • Asset Value
  • Equity Value
  • Enterprise Value
  • Liquidation Value

In understanding and interpreting the “value” of your business it is important to recognize that there are many different “types” and levels” of value. The most common scenario involves the estimation of “fair market value on a going concern basis" for the entire company.

You can obtain a FREE preliminary value of your business by going to our Summit Business Valuator and inputting some basic information. Every business owner should experience this valuation. Then, in less than ten minutes of putting additional information into the Valuator, you can obtain a complete report on your business. You will then be able to utilize the Valuator for a full year to massage your numbers and improve your business planning.

Click here to begin!

Posted in New Developments

08August

Tax Extenders and IRA Charitable Rollover

washingtonOn August 2, the Senate Finance Committee, on a bipartisan vote of 19 to 5, passed the Family and Business Tax Cut Certainty Act of 2012. Six Republican senators joined 13 Democrats to support the bill. This is one of the first tax bills with bipartisan support this year. The tax extenders bill has an anticipated cost of $200 billion over 10 years and is not offset by tax increases.

Approximately 75% of the current tax extenders are included in the bill. There are several significant provisions.

1) AMT Patch - The exemption for alternative minimum taxes for 2012 is indexed to $50,600 for individuals and $78,750 for married couples filing jointly.

2) Teachers' Expenses - The $250 above-the-line tax deduction for teachers, to offset the cost of books and school supplies, is extended for two years.

3) State and Local Sales Tax - The itemized deduction for local taxes is extended for two years.

4) IRA Charitable Rollover - The option for IRA owners over age 70½ to transfer up to $100,000 per year directly from an IRA custodian to charity is extended for two years.

5) Research and Experimentation Credit - The credit equal to 20% of qualified research expenses is extended for two years.

6) Enhanced Gifts of Food Inventory - The enhanced deduction for gifts of "apparently wholesome food" by taxpayers is extended for two years.

7) Appreciated Subchapter S Corporation Gifts - A provision that facilitates gifts of appreciated property by S Corporations is extended for two years.

Approximately 25% of the existing tax extenders have been omitted. This is a significant change from prior years in which all of the extenders have been included in the bill. Two charitable extenders were not included. These are the enhanced charitable deduction for gifts of book inventories to public schools and the enhanced deduction for corporations who make gifts of computers for educational purposes. Both provisions lapsed on December 31, 2011.

Senate Finance Chair Max Baucus (D-MT) stated, "The Senate Finance Committee worked together to craft a bipartisan extenders package. This effort has proven that legislating can still be done if both sides work together."

Senator Orrin Hatch (R-UT) continued, "This legislation demonstrates that there is a will to subject long-standing tax policies to the full and much-needed public scrutiny of the American people. This is a first step towards the ultimate goal of comprehensive tax reform that shows that there is a path to resolving the challenges we face as a nation."

Editor's Note: There are now reasonable prospects for passage of the tax extenders by the Senate. The key question of interest to charities and their donors is whether the House will also act on the tax extenders. If the House acts prior to September, it will permit charities to promote the IRA Charitable Rollover this fall. Many potential IRA rollover donors are waiting to see if Congress extends this gift plan. If it is passed, the IRA rollover will be valid for qualified gifts from January 1 to December 31 of 2012.

House Passes Tax Cut Extension and Fast Track Process

On August 1, the House of Representatives passed two different tax bills. The Job Protection and Recession Prevention Act of 2012 (H.R. 8) extends taxes at current rates for one year. It differs from the Senate plan in that the income and capital gains tax rates for upper-income taxpayers would be maintained at the current levels for 2013.

The Pathway to Job Creation through a Simpler, Fairer Tax Code Act of 2012 (H.R. 6169) creates a "fast-track" process for major tax reform in 2013. The fast-track bill includes specific goals for tax reform. These include two personal income tax brackets of 10% and 25%, a corporate tax rate of 25%, a tax system that raises revenue equal to 18-19% of gross domestic product and a worldwide tax system. The lower rates are achieved by limiting most itemized deductions.

The fast-track system creates specific procedures designed to force the Senate Finance Committee and the House Ways and Means Committee to submit bills for votes to the full House and Senate by the middle of 2013.

The White House opposed both of the House bills. It believes that extending the tax cuts for upper-income Americans "would hurt the economy both by increasing the long-term deficit and also by taking money out of the pockets of the families most likely to spend it in the near term."

It also criticized the fast-track legislative method. The White House is concerned that a fast-track system for tax bills would lead to tax cuts for high-income households and corporations.

Editor's Note: It is not likely that there will be any major action on these bills prior to the November election. However, this positioning by both parties will have major significance for the 2013 tax reform efforts. The level of activity in Congress suggests that many members of Congress now think it is quite probable that there will be major tax reform next year.

Gifts to Disregarded Entities are Deductible

In Notice 2012-52; 2012-35 IRB 1 (1 Aug 2012), the Service approved gifts to disregarded entities created by qualified Sec. 501(c)(3) charitable organizations. Many charities have created single-member LLCs (SMLLCs) for various purposes. A common strategy is to create an SMLLC to receive, hold and manage real estate gifts. The SMLLC may reduce the potential liability risk to the parent. If the real estate is subsequently sold, the cash proceeds may be then distributed to the charitable parent.

Charities and their advisors have long advocated charitable deductions for gifts to the disregarded entities. In Notice 2012-52, the Service approves the use of disregarded entities and confirms that gifts to those organizations will be deductible.

The Notice states, "If all other requirements of Sec. 170 are met, the Internal Revenue Service will treat a contribution to a disregarded SMLLC that was created or organized in or under the law of the United States, a United States possession, a State, or the District of Columbia, and is wholly owned and controlled by a U.S. charity, as a charitable contribution to a branch or division of a U.S. charity."

The Notice encourages charities to disclose the parent-SMLLC relationship on a receipt or contemporaneous written acknowledgement to the donor. For example, an SMLLC owned by Favorite Charity might include this language on its receipt:

"SMLLC is wholly owned by Favorite Charity of City, State. It qualifies as a branch or division of Favorite Charity. Under Notice 2012-52, gifts to SMLLC are qualified for charitable deductions under Section 170 of the Internal Revenue Code."

Appraisal Reconsidered and Rejected

In Steven Rothman et ux v. Commissioner; T.C. Memo. 2012-163; No. 17547-10 (Jun 2012) the Tax Court denied a $290,000 façade easement charitable deduction because the appraiser had used a percentage method. Following a decision by the U.S. Court of Appeals for the Second Circuit in Scheidelman v. Commissioner, 682 F.3d 189 (2 d Cir. 2012), the taxpayer petitioned for a reconsideration of that decision.

In Scheidelman, the Court of Appeals stated that a percentage appraisal method with accompanying data could comply with the Reg. 1.170A-13(c)(3) requirements of the Income Tax Regulations. Based upon that decision, the taxpayers requested reconsideration.

In Steven Rothman et ux v. Commissioner; T.C. Memo. 2012-218; No. 17547-10 (30 July 2012) the Tax Court reviewed the 15 requirements of a qualified appraisal. It vacated the portion of the original Tax Court opinion that disqualified the appraisal because of the percentage method, but it noted that there were at least three specific reasons why the Rothman appraisal still did not meet the requirements.

The appraisal did not disclose the terms of the agreement between the National Architectural Trust and the donors, it did not communicate the existence of mortgages on the property and it appraised a property interest greater than the one contributed.

Because the appraisal failed to satisfy eight of the 15 requirements, it still is not valid. However, the taxpayers are permitted to present to the Tax Court their basis for claiming a failure due to reasonable cause.

Applicable Federal Rate of 1.0% for August -- Rev. Rul. 2012-21; 2012-32 IRB 1 (18 July 2012)

The IRS has announced the Applicable Federal Rate (AFR) for August of 2012. The AFR under Section 7520 for the month of August will be 1.0%. The rates for July of 1.2% or June of 1.2% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2012, pooled income funds in existence less than three tax years must use a 1.8% deemed rate of return.

Posted in New Developments

08May

Help Clients Plan Giving

Charitable planning is not something financial advisers should give away.

pigVIEW ORIGINAL POST ON INVESTMENTNEWS.COM

Advisers who help clients develop and execute a philanthropic plan can charge fees for those services just as they charge for investment and financial planning. That will benefit their firm's bottom line and also make clients more satisfied, according to those who specialize in philanthropic giving.

“The clients we want are already fully engaged in philanthropy, even if they won't put that big word on it,” said King McGlaughon, chief executive of Foundation Source Philanthropic Services Inc. “Ignoring that is perilous to your relationship as an adviser and to the client's good health.”

Surveys show that at least 75% of U.S. households give to charities. Typically, gifting rises as wealth increases.

“People pay for intergenerational planning; it can support revenue,” said Yale Levey, an adviser with Royal Alliance Associates Inc.who added philanthropic planning to the wealth advice he provides to clients eight years ago.

Posted in New Developments