Tuesday, April 30, 2013

Small business valuations are heading south; don't shoot the messenger.

By Jonathan Copley

The age of 67 is effectively becoming the new retirement age with the phasing in of changes in social security rules reflecting increased longevity. Given the post-WW2 birth explosion, which lasted from 1946 to 1960,  the United States will therefore witness a tidal wave of independent business owners trying to unload their businesses and retire between 2013 and 2027.

What does this mean for business valuations? 

Most small businesses are valued at a multiple of profit. The great recession of 2008 caused substantial downward pressure on profit. As we entered 2013, there were signs that the economy was picking up, including most-tellingly increases in housing starts. Business owners can expect to see the profitability side of equation picking up. 

On the other hand, despite increased consumer and business confidence, as we move into mid 2013, there is substantial downward pressure on the multiples. Why?
There is already over-supply as a result of the last recession. Those baby-boomers who were ready retire between 2008 and 2012 were caught in what was the worst recession since the thirties.  Many refused to accept what appeared to unreasonable low-ball offers. After all, they "knew" from their experience with real estate and the stock market that you don't sell when the overall market is down. For decades, the strategy of "wait and see" has paid off in these markets, at least in nominal, if not always in inflation-adjusted terms. 

But this strategy of "wait and see" may not work when it comes to selling a small business. Why? Lifestyle issues dictate that owners may not be able to wait for more than a few years, for fear they will miss those golden retirement years when they are still healthy enough to complete their bucket-list. And during business negotiations time pressure on one party favors the other party.

Even worse news...as the number of baby-boomers reaching retirement age continues to climb over the next few years, thereby increasing the already over-bloated pool of businesses available for sale, the number of potential buyers will likely dwindle. The rapidly declining cost of technology allows more and more entrepreneurs to start their own businesses and access far-reaching markets. Sure, many will fail. But they're more likely to try again, than take on the twin albatrosses of traditional business…bricks and mortar; and a fixed payroll, (as evidenced by the growing army of 1099ers.)

Am I suggesting that valuation of traditional small businesses will continue to decline over the next decade? Yes, that is very likely. The benefit of post-recession increases in profitability will be more than offset by declines in multiples.

What should you do if you're a small business owner approaching retirement age? 

1) Now is the time to make sure all the business fundamentals are in place; cash flow management; financial controls, web reputation; elimination of unprofitable relationships etc.

2) Obtain an independent third party valuation by a professional valuation firm to get a realistic sense of what your business is currently worth. Remember that listing-brokers are not independent in the sense they may be over-anxious to under-value the business to increase the chance of obtaining a sale.

3))  Don't be tempted to wait and see. You are not going to be healthy forever. The baby-boom demographics are not going to change. Gen X is not going to abandon its own start-up dreams and suddenly re-embrace the high cost of getting into traditional businesses.

4)  Don't shoot the messenger. In other words, come to terms with the multiples used in the independent valuation.  Accept the hand you've been dealt and focus on dealing with the profitability side of the equation, which to a large degree is within your control. 

About the author:
Jonathan Copley is CEO of business consulting firm CFOCare Inc, which provides business valuations; M&A and strategy consulting. He is the founder of Grow50 a consortium of leading professional firms, which helps entrepreneurs plan, fund, grow, operate and sell. He can be reached at jc@cfocare.com.

Thursday, April 18, 2013

Twenty Dirty Words to Avoid in Business Pitches

Following on from my recent blog about highly defective images to avoid including in pitches to investors, here's a list of dirty words which can doom any would-be entrepreneur.

  • Landmark
  • Revolutionary
  • Groundbreaking
  • Breakthrough
  • Turnkey
  • State of the art
  • Best in class
  • Cutting-edge
  • Leading-edge
  • Best-of-breed
  • Awe-inspiring
  • Decadent
  • Sumptuous
  • Breathtaking
  • Extraordinary
  • World-renowned
  • World-class
  • Stunning
  • Beautiful
  • Dramatic

 The list was reported by PR firm Ragan.com, based on information supplied by Michael Smart, principal for MichaelSMARTPR,and New York Times technology columnist David Pogue.

Saturday, April 6, 2013

Confirmed! Washington is number one state for making a living

MoneyRates,com is now confirming what Washingtonians have known for a long time...our state is the best place to make a living.
Now that its official, we can look forward to more investment flooding into the region which is all good news for entrepreneurial ecosystem! Here's an extract from the article that was just published in Forbes Magazine
If you’re struggling to find employment; unhappy in your current job; or disappointed with your paycheck — relocation might be the best solution.
Factors like workplace conditions, cost of living, income, taxes, and unemployment rates can differ vastly from state to state.
MoneyRates.com, a source of information on bank rates, personal finance, savings accounts and investing, just released its third annual ranking of the best and worst places to make a living.
It ranks all 50 states based on income, taxes, cost of living, unemployment, and workplace environment data. The information is gathered from the Bureau of Labor Statistics, C2ER, Tax-Rates.org, and Gallup-Healthways Well-Being Index.
“These criteria were chosen because they represent all aspects of making a living,” says Richard Barrington, CFA, senior financial analyst with MoneyRates.com. “What chance you have of finding a job, how much you are likely to make, how much you get to keep, how much you can buy for your money, and what it’s like to work in your state.”
At the top of the heap this year is Washington.
“Washington is one of only eight states where the average wage is in excess of $50,000 a year,” Barrington says. “However, Washington is the only one of those eight states where high wages are not offset somewhat by a high cost of living. Each of those other states has a cost of living at least 20% higher than the national average; in Washington, the cost of living is only 2.5% higher than the national average, so the state’s residents get the benefit of high incomes without an unusually high cost of living.”
In addition, Washington has no state income tax, so its residents get to keep more of those high salaries, he says. “Finally, Washington also got an above-average ranking in a Gallup-Healthways poll about workplace environment.”...

Friday, April 5, 2013

Key issues in tax valuations

SRR identifies 10 key issues to consider in performing tax valuations.

... The following list represents a “Top Ten” list of common issues encountered in tax-related valuation engagements.

1 Standard of Value

The purpose of a valuation engagement dictates the requirements as it pertains to the appropriate standard of value. The appropriate standard of value from a U.S. tax law perspective is “Fair Market Value,” which is defined as the price at which property would exchange between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both having reasonable knowledge of the relevant facts (Treas. Regs. §20.2031-1(b) and §25.2512-1; Rev. Rul. 59-60, 1959-1 C.B. 237).

For financial reporting purposes, the standard of value is “Fair Value”, which is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (FASB ASC 820-10-20). Although there are specific (and often subtle) differences between the Fair Market Value and Fair Value standards, often the value of an asset valued under these premises of value are very similar, but in certain cases may differ materially.

Fair Market Value and Fair Value are two of the most common valuation premises, however, there are several other standards of value that may be appropriate to consider given the circumstances surrounding a valuation analysis. For instance, one may consider investment value (the value based on a specific investor’s assumptions, which may include revenue enhancement synergies and/or cost synergies upon combination), among others. The assumptions used to value an asset or equity interest under this standard of value is typically dramatically different than otherwise. The generally accepted view is that Fair Market Value should exclude such synergistic benefits. However, courts in certain situations have contemplated the available universe of buyers and the potential impact from a valuation perspective. Careful consideration and analysis should be performed with respect to consideration of such factors when determining value. Correspondingly, if you are relying on a prior analysis or work, it is critical that you confirm that the valuation analysis was prepared under the exact same premise required.

2 Asset Value vs. Equity Value

Depending on the purpose of the valuation, the appropriate conclusion may be either an asset value or an equity value. For situations where an equity value is needed (either the entire equity value of a business or a specific ownership interest in the equity), the valuation process may begin with determining the enterprise value of the business (i.e., net working capital plus tangible and intangible assets). The enterprise value of the business is correspondingly equal to the total invested capital (i.e., debt plus equity capital) of the business (see the table below in this regard). In order to value the equity of the company, enterprise value is estimated first and then total debt and other liabilities are subtracted.

Some valuation engagements require the conclusion to be an asset value. An example in this regard is a valuation completed for purposes of a Subchapter C to Subchapter S conversion. For this analysis, the appropriate conclusion is total asset value (which is generally equal to enterprise value plus current and long-term non-debt liabilities). Given the different requirements, it is critical that company management consult its tax and valuation advisors to ensure the output of a valuation analysis is consistent with the respective tax requirements.

3 Highest and Best Use

The highest and best use of an asset or business must be considered when estimating value under the Fair Market Value premise of value if the subject interest is controlling in nature. In broad terms, highest and best use is determined based on the use of the asset by market participants that maximizes the value of such asset, even if the intended use of the asset by the business is different than a general market participant. For example, a real property asset may be used for manufacturing purposes by its owner, but a market participant may maximize value by redeveloping the property for residential use. Further, the valuation of a business requires an investigation into “the possibility that the business enterprise may have a higher value by liquidation of all or part of the business than by continued operation as is.”1 In situations where a business is not generating a sufficient return on its underlying assets, a hypothetical orderly liquidation value may be a more appropriate method to value the business as compared to a going concern value.

4 Transfer Pricing Issues

Commonly, companies are engaged in business transactions with related parties. These transactions not only include the purchase and transfer of goods, but can also include payments for services provided such as building rent, royalties, and licensing fees associated with the use of intangible assets, and an allocation of corporate overhead expenses. Accordingly, it is important to examine related party transactions to confirm market rates. For example, in situations where a royalty rate charged for the use of a technology asset is significantly divergent with a market royalty rate charged for comparable technology (based on market observations), an adjustment is made to incorporate a market rate when performing the valuation.

5 Investments - Minority Interest Ownership

The assets of many companies include ownership interests in other related or unrelated entities. Typically, the balance sheet values of these investments do not reflect Fair Market Value when the ownership interest is a minority interest. Investments that represent an ownership interest of 50% or lower are either recorded on the balance sheet at historic cost or accounted for by the equity method of accounting. Both of these methods may not reflect Fair Market Value. Whether or not the Fair Market Value of these investments should be computed as part of a valuation analysis largely depends on the materiality of the investment relative to the value of the subject company as a whole (as well as the estimation of the potential magnitude of the difference between book value and Fair Market Value).

6 Related-Party Notes Receivable

Companies comprised of multiple legal entities often provide financing through intercompany borrowings. Specifically, one legal entity will provide a loan to another legal entity, and the entity providing the funds will record a note receivable on its balance sheet. Over time, due to declining financial performance of the payor, there may be a low probability of the loaning legal entity collecting its receivable (as the other legal entity may not have the wherewithal to repay the loan). As such, it is important to closely analyze the financial condition of the opposite party in such loan scenarios to ensure that there is economic value associated with the note receivable. If the related entity does not have the wherewithal to repay the loan, the note should be marked down to the amount that could be repaid (if any). Further consideration should be given with respect to the legal aspects of such notes and whether other entities may be responsible with respect to the payment of the loan or if other assets may be attached as collateral.

7 Cash Pool Agreements

Commonly, companies with complex legal entity structures incorporate a cash pooling system to manage the funding requirements of the company as a whole. In a typical cash pooling structure, either the overall parent company or a legal entity that is specifically designated as the finance entity will manage the daily working capital requirements of all of the participating legal entities. Each legal entity regularly transfers (or “sweeps”) all or a portion of its surplus cash to a single bank account and, when necessary, withdraws funds from the bank account to fund operating expenses or other expenditures. This type of funding scenario is popular because it serves to reduce external borrowing as loss generating entities are able to fund operations through the cash generated by profitable entities. Furthermore, the parent company or finance entity can utilize economies of scale to negotiate more favorable lending rates with banks when external borrowing is necessary or desired.

In a valuation analysis, the treatment of a cash pool liability or asset is often not a straight forward decision. With respect to cash pool assets, the valuation issue is similar to that described above for related party notes receivable. When a company (or legal entity) has a cash pool liability recorded on its balance sheet, the critical issue to solve in a valuation analysis from a legal perspective is to determine whether to treat the liability as debt or equity. Although “black and white” rules for making this determination do not exist, guidance is provided within IRC § 385 (Treatment of Certain Interests in Corporations as Stock or Indebtedness) as well as prior court cases. Specifically, IRC 385 lists the following factors to consider:

i. Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest

ii. Whether there is subordination to or preference over any indebtedness of the corporation

iii. The ratio of debt to equity of the corporation

iv. Whether there is convertibility into the stock of
the corporation

v. The relationship between holdings of stock in the corporation and holdings of the interest in question

vi. Effect of classification by issuer

The factors addressed in various historical court cases have been similar to guidance provided by IRC 385. Overall, the courts have concluded that no one specific factor in and of itself determines whether an interest is debt or equity. Rather, the facts and circumstances need to be considered collectively prior to making that determination.

8 Net Operating Loss Carryforwards

If a legal entity owns net operating loss (“NOL”) carryforwards, it is important to carefully analyze the specific terms and conditions associated with the NOL carryforwards to ensure they are properly incorporated in a valuation analysis. Examples of important factors to consider include expiration dates, limits on use (e.g., Section 382 limitations), and general rules regarding which legal entities are allowed to utilize the NOLs.

9 Discount Rates

In certain circumstances, the weighted average cost of capital, or discount rate, utilized in the valuation of a legal entity may be calculated for the entity being valued on a stand-alone basis. As a result, the concluded discount rate may likely be different than the parent company’s overall discount rate. Some reasons that contribute to differences in the discount rate include: company size, industry risk, and capital structure. If the legal entity is significantly smaller than the overall parent company, a larger risk factor related to size may be appropriate. Further, the operations and markets served by the legal entity may not be consistent with the parent company’s other divisions and business units, and thus, the selection of an appropriate beta may change. Finally, the capital structure conclusion should reflect optimal industry levels and also consider the legal entity’s specific borrowing capacity.

An additional issue to consider when calculating an appropriate discount rate is the location of the legal entity’s business operations. Investors require investment returns by considering the risk associated with the location of the legal entity’s operations as opposed to the location of the legal entity’s capital sources. Political, economic, and financial risks, in addition to industry operating risks and risks specific to the subject legal entity should be considered in measuring an investor’s required return on the entity’s projected cash flows.

10 Legal Entity Ownership of Intangible Assets

In a tax valuation, it is important to consider the fact that intangible assets are often legally owned by a separate legal entity that is specifically designated for intellectual property management. In this instance, a valuation expert needs to investigate legal entity ownership of intangible assets and ensure the valuation analysis reflects such ownership. That is, even though the economic cash flows associated with an intangible asset may be generated by the operations of one entity, the legal owner of the intangible asset needs to be compensated such that the overall value of the intangible asset resides at that entity.


In preparing a valuation analysis for tax purposes, care must be given with respect to the 10 factors/issues mentioned above. This “top ten” list certainly does not capture every possible valuation issue to contend with, but it does reflect several issues that are commonly encountered. The bottom line is that these issues (and others depending on the facts and circumstances) need to be considered and properly accounted for in order to prepare a bullet proof valuation analysis that will withstand scrutiny in tax court

Fall 2011
Jay B. Wachowicz
Michelle Brower
Andrew J. Robinson