You Probably Don’t Know the Actual Value of Your Company

And not knowing is eventually going to cause problems. 

Over the course of thousands of client interactions one statistic stands out above all others: entrepreneurs drastically overestimate the value of their company.   It’s not surprising, of course.  It falls right in line with human nature: we all think our house is perfect, no one thinks they have an ugly kid, and owners overprice the asset that they have worked so hard to build.  It’s funny – when we sit down with entrepreneurs they fundamentally realize this – they invariably chuckle along knowing it’s a fundamental truth.

So what is the big deal?

Well let’s talk some other facts: studies consistently show that a company will typically make up over 80% of an entrepreneur’s net worth.  For the vast majority, liquidating (i.e. selling) that company is going to be critical to the success or failure of realizing their retirement goals.  That ordinarily wouldn’t be a big deal if that company were a highly liquid asset.  If you needed to sell some Google or Facebook stock you could do that this afternoon.  But privately held companies are certainly not as liquid as a publicly traded stock, and selling one is no sure bet.

More facts: studies show that only 20% of companies are successful in selling in their first attempt.  That is just an abysmal success rate.  The number one reason that companies don’t sell?  It’s probably not a surprise: the market won’t support the price that a seller is willing (or able) to sell at.  Even worse is the number two reason that companies do not sell: in some cases there simply is no market for the company – meaning that not a single market participant has found the company attractive enough to enter into negotiations.

Putting this all in context: if you are an entrepreneur you probably have most of your eggs in one basket.  You also probably don’t know what those eggs are worth.  And there is only a 20% chance that you’d be able to successfully sell your company… likely because there is a gap between value expectations.

There has to be a better way, right?

The Value Engineering Playbook

Let’s imagine I want to go visit my sweet old Aunt in Schenectady, NY.  I’m probably going to need to know at least two things: where I’m starting from, and the location that I’m trying to get to.  I can’t really get on the right roads if I don’t know the starting point, and I’m certainly not going to end up in the right point if I don’t know the destination.  I’d also probably want to know a couple of other things to improve my odds of getting there, right?  Like… how far away is Schenectady?  Is my car in good shape?  Do I have enough gas?  But just like you, I’m sure there is definitely a mental playbook that I’d run to get to Schenectady, right?

There’s a playbook for getting to “Schenectady” with a company too.  In the life of a business owner the starting point is your Current Market Value, and the destination is the number you’ve worked out in your financial plan.  Is your car in good shape?  Right – that’s your company.  And gas?  Well that’s probably capital.

Running the table when it comes time to sell is going to require you to get an accurate insight into your company’s value now, how much of a gap there is between where you are trying to go, and executing on a legit plan in order to close that gap.

Of course it all starts with knowing Current Market Value.

How Long is a Valuation Good For?

It’s a logical question from business owners: how long is a valuation good for? The short answer:  probably for about a year. The longer answer: it depends.

Context is critical

Business valuations are always completed for 1) a particular purpose and 2) at a specific point in time. While a valuation will take into account a wide range of data – future projections, management’s past ability to hit projections, prior performance, structural trends in an industry – it remains that the valuation is as of a certain date.

For instance, here is what the American Society of Appraiser (ASA) has to say on valuations:

The determination of value for a business is always done as of a specific date; however, the final opinion of value most always considers historical information as well as the future projections about the subject company and its industry. Each day there could be slight modifications of value due to changes in the capital structure of the company; however, in general practice, if there are been no significant changes in the operations of the business or its capital structure, annual updates may satisfy most uses of the appraisal report.

The ASA definition gives us a starting point. There can be small fluctuations on a daily basis in value but on a macro level, a valuation is usually good for about a year.  However, there are situations when a valuation is not good for a year, which is why understanding context is critical.

What might change your value within a year?

When we say “about a year,” this generally assumes that nothing has materially changed that would impact our analysis.  For example:

  • Has something happened to materially impact revenues?  Or earnings?
  • Has there been a change of control?
  • Is there a new management team?
  • Loss of a key sales person?
  • Legislation that has a material impact on your industry?
  • Has the purpose of the valuation changed?

Any of the above might impact the validity of a valuation inside the one-year period.

How Can a Change in Purpose Affect Value?

One aspect of value many business owners don’t consider is the impact that “purpose” has on the validity of a valuation.  For instance, we are likely to arrive at vastly different conclusions if a valuation is done for a minority buyout vs. a strategic purchaser.  Understanding the context of the valuation is critical – and by default, a change in context (or purpose) is likely to impact value.

Valuation and Divorce: A Case Study in Purpose

A great example of valuation purpose affecting value is when a valuation is performed in the context of a divorce.  Valuations are often required when a privately held business is part of a marital estate.  In order to perform a division of property the parties must know the value of the asset, and in the absence of a public market price a third party valuation is required.

If we assume for a moment that we are valuing a minority interest (50% or less, lacking elements of control and liquidity), as a valuation analyst we would ordinarily consider applying a Discount for Lack of Control and/or a Discount for Lack of Marketability. This may result in a discount from the pro rata share of the business of anywhere from 20-50%.

Example 1:

In many jurisdictions, the courts have stepped in and limited the ability to apply so called discounts.  In order to not “punish” an exiting spouse, the valuation is precluded from applying these discounts, instead developing a value that is higher than what we would conclude if we were performing the value for a different purpose.

Example 2:

Staying with the divorce scenario, in many situations as a valuation analyst we might look at the impact of “personal goodwill’ on the overall value of a business. That is to say, how much value is attributable to an individual owner vs. the enterprise itself? This is very common in medical and professional practices, or scenarios where the “owner is the business.”

Similar to limiting discounts, states take wildly differing views on the treatment of personal goodwill in divorce matters.  In many states personal goodwill is considered a marital asset, this divisible in the separation of assets.  In others, personal goodwill attaches to the individual and is separated from our valuation.

Conclusions

Given the above scenarios, a valuation performed in the context of a divorce could have a materially different finding than a valuation performed for, say, exit planning purposes.  In our examples above, not only does purpose affect the validity of a valuation, but so does jurisdiction!

[This article by Dan Doran originally appeared on Axial in 2015]

The Buy-Sell Agreement: 9 reasons you need one

When forming a business, one of the first things every entrepreneur should think about is their ultimate exit. For most, this is the farthest thing from their mind.  As any corporate attorney will tell you, in the same way in which you would plan to protect your children with the creation of a will, your business should also be treated with kid gloves. A Buy-Sell Agreement should be a top priority. Think of it as a prenup for business partners. Read more

How Shareholder Compensation Affects Value

Question:  What’s the going rate to hire a business owner these days?  Or put another way… how much should an owner-operator pay themselves? In some privately held companies that may be a question that is answered by the Board of Directors.  But in most privately held companies it’s a question answered by a single person: the one writing the check.  Owner compensation is really an arbitrary matter for just about every payroll run… except on the days that someone is trying to value / price a company.

Why’s that?  Well, when I pay myself an extra buck where does it come from?  Profit.  And in most cases what is the basis of establishing value?  Profit.  See where I’m going with this?   We deal with a wide array of valuation engagements in which shareholder compensation becomes a sticking point.  Sometimes it’s a bit of gamesmanship (negotiating an M&A buyout), others it’s a highly litigated matter (how does owner comp impact a) valuation and b) alimony in a divorce matter?)

Making matters even more “interesting” – in some instances it is proper to adjust shareholder compensation as part of adjustments to the financial statements, while others an adjustment isn’t proper at all.   Given that changes in owner comp will more often than not have a direct – and often material – impact on the calculated value of a company, you can imagine that it’s often a bone of contention.

Why Adjust Compensation?

Oftentimes a working shareholder will use their salary as a mechanism to withdraw profits from the business.  The W2 compensation thus reflects not their actual contributions to the business as an employee, but rather their stature as a shareholder.  For businesses with a single shareholder (or perhaps a small group), the owner doesn’t draw a distinction between salary and dividends: it’s all the same pile of money from which he or she can pay themselves.

Take for example a company with $2.5 million in revenues and $100k in earnings, and a single shareholder that takes a salary of $1 million (“Scenario 1” below).   That same shareholder might choose to pay themselves a salary of $100k and receive the rest as a dividend.  In both cases the cash available to the shareholder is the same.   Makes sense, right?


Valuation is most frequently a function of earnings.  And if that’s the case are we to conclude that the companies in Scenarios 1 and 2 above are worth the same? If we assume that this business, other things being equal, is worth 5x earnings… is $500k a reasonable valuation?  Likely not.  A more reasonable interpretation is that a portion of owner salary is actually a dividend in disguise.  Adjusting to a “normalized” salary would increase earnings, thereby result in a more accurate value.

So What’s the Big Deal?

Adjust the salary to a market rate, right?  Therein of course lies the problem.  What is market rate?  To replace the day to day services of the shareholder, is the proper rate $100k?  Or 500k?  Or 900k?  Using our example above, adjusting to $100k in salary would increase valuation by $4.5 million.  Adjusting to $900k would only increase the valuation by $500k.

These sorts of adjustments can cause significant strife among parties.

When NOT to Adjust?

All shareholders are not created equal.  If the shareholder lacks “control” – i.e. the ability to adjust their own salary- it’s unlikely that a change is warranted.  For instance, imagine a company in which Suzanne Shareholder is the VP of Sales and owns a 7% stake in the company.  She’s paid $1 million per year, which is far above peers in similar roles within the industry.  She reports to the CEO (and majority owner) who establishes her salary.

Is a compensation adjustment warranted? Maybe! We’d probably look at the purpose of the valuation to understand whether or not to adjust.  If we are valuing JUST her 7% interest- perhaps for a divorce matter – then an adjustment likely wouldn’t be warranted.  Why?  Because her comp is unlikely to change as a result of the divorce.  On the other hand, what if we are valuing the entire enterprise and Suzanne is likely to accept a more reasonable salary in conjunction with the sale?  Good chance we’d adjust.

How to Get Beyond the Strife?

We’ve got a couple of moving pieces here: first, understanding whether or not an adjustment to shareholder compensation is warranted.  That’s totally in the wheelhouse of us as the valuation expert.  Second, we need to understand what to adjust to.  Options include:

  • Option 1: Rely on third party data. In some industries there is robust data available for purchase.
  • Option 2:  Rely on your valuation expert.  We have a sense for what CEO’s are paid for companies in certain industries and sizes.  We can make an educated guess – but we are NOT experts on executive comp.
  • Option 3: Hire a compensation expert to analyze what it would cost to source a replacement.  There is a material costs to going this route, but in some cases the benefit may be worth it.

Ultimately your valuation expert can help guide you to the best decision based on your particular circumstances.

Tip: In Buy-Sell Agreements / Operating Agreements, consider including language regarding compensation in order to avoid this very conflict down the road.  

Understanding Terms: Main Street vs. Middle Market

We often throw around the terms “middle market,” “lower middle market,” and “Main Street.”  These are pretty common terms in the finance, banking, and M&A world, but probably less so to most business owners and entrepreneurs.  For the sake of clarity we thought we’d dive in.

 

Defining Main Street vs. Middle Market

It seems that everyone has their own definition, but here is ours.  Because of the wide range of company sizes within the definition, the middle market can be further broken down into the following:

  • Main Street-  <$5 million of revenues
  • Lower Middle Market – $5 – $50 million of revenue
  • Middle Market – $50 – $500 million of revenue
  • Upper Middle Market – $500 – $1 billion of revenue

What Does it Matter?

Company size has an impact on all sorts of considerations in the valuation world.  Perhaps the first is the so called “size premium” – the notion that larger companies have higher relative valuations.  The reason for this is somewhat straightforward: larger companies are able to better diversify risk and have access to cheaper capital.

Related to the above, business sellers need to consider their target audience when going to market.  If you are a Main Street company, chances are that your buyer pool is an individual who is looking to buy a business or maybe a lower middle market company.  Chances are exceedingly slim that you are in play for a private equity buyer.

On the other hand, if you are a lower middle market company, your target acquirer is likely in your “bucket” or the next higher.  You very well could be in play for a private equity deal… though depending on a range of factors perhaps as an add on rather than a “platform” company.  Private equity groups offer healthy multiples and strategic acquisitions, driving up value, compared to an individual buyer looking for a quality investment.

But in the end, what is the main importance? Since business folk are always throwing these terms around it’s always good to get a baseline so we are all speaking the same language.

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What is working capital? Why negotiate a working capital adjustment in your purchase price?

When a buyer values a target company, the buyer’s valuation is based on the target company’s financial condition on a specific date.  In most instances, several months pass between that initial valuation date and the closing date, which is when the buyer acquires the target company.  Purchase price adjustments need to be negotiated to reflect changes in the target company’s financial condition between those two dates.

According to the American Bar Association’s 2011 Private Target Mergers & Acquisitions Deal Points Study, 82% of private company acquisitions in 2010 included purchase price adjustments. Read more

Understanding Seller’s Discretionary Earnings

So you’ve heard someone throwing around the term “Seller’s Discretionary Earnings” and you find yourself thinking “my earnings aren’t discretionary at all.”  Let’s jump in and understand this oft-misunderstood term (which also, confusingly, goes by “Seller’s Discretionary Income,” SDE, and SDI…). Read more

How To Get a Business Loan

Your small business is ready to grow and you need a loan to make it happen. Just like with a personal loan or a mortgage, you will want to shop around and find the best rate and terms to meet your needs. Being prepared will be key to expediting the process. Follow these four basic steps and watch load offers roll in.

1.  Improve your personal and business credit scores.

Read more

3 Secrets to Making Your Business More Sellable

One of the challenges that we often face is correlating value to “sellability.”  In many cases a business may have value to the owner, but there may be a very limited market for the company.  (In fact, this notion is the basis of the concept of a Discount for Marketability.) For example, a small  3-person company with a single working owner may generate significant value for the owner.  But that same business might not have significant conveyable value to a buyer. Read more

Understanding Valuation Adjustments

One common step in all business valuations is the “search for adjustments” – whether it be a public company with GAAP accounting or a small pass through entity.  Valuation analysts are (almost) always looking at past performance as a proxy for future value.  In doing so, we need to understand what the “real” earnings capacity of the company is.  Unfortunately, the story isn’t always so clear.  Myriad  factors cloud the question of “what’s real?”  Nonetheless, analysts work through a process to start quantifying these changes – or Adjustments – to earnings to realizing the real number.   From there, we can work through modeling performance, risk, and ultimately value.

Why do we care?  A few reasons: Read more