Business Valuation for Transition – Income Approach

Preface: “Science has not yet mastered prophecy. We predict too much for the next year and yet far too little for the next 10.” –Neil Armstrong

Business Valuation for Transition – Income Approach

Further to the prophecy attribute of business valuation, we further consider the income approach to business valuation. This approach is a multi-factor approach that converts expected future economic benefits into a business valuation estimate based on historical financial precedents. Although a host of methods and valuation models are available for the income approach to valuation, often they include either a capitalization of normalized earnings and free cash or discounted cash flows. The Treasury Method of capitalizing excess earnings is a less frequently applied income approach to valuation.

For the income approach to accurately represent a reasonable estimate of business value with the capitalization method, a valuation analyst must first normalize and perhaps appropriately weight the “historical” earnings of a business. This can include normalized owner’s compensation, normalized rents, normalized wages, depreciation normalization, normalization of extraordinary gains or losses, and discretionary items including charitable contributions, travel, etc.

Weighted earnings approaches to income normalization typically represent a more moderate estimate of cash flows and smoothed effect on capitalized earnings. For instance, a valuation estimate that includes consideration of only one year of earnings is usually subject to extreme variables in value. Typically valuations of successful businesses will look at five (5) years of weighted earnings, providing a more realistic expectation of future estimated income and cash flows.

Additionally, there is much more than simply capitalizing weighted earnings or discounting expected future cash flows or earnings for a realistic estimate of value with the income method. When valuing a business for purposes of equity percentages, a valuation analyst always analyzes the working capital and cashflows. For instance, analyzing only the balance sheet with an asset approach valuation omits the dividends and return on investment equation of an investment grade asset.

Analyzing only the income statement omits the free cashflows required for debt service and working capital needs including cash overdraft concerns. A small business with say substantial cash overdrafts during seasonal inventory peaks or sales troughs will also require a valuator to analyze more than annual normalized earnings. An example would include a business needing 70% of current earnings cash flows to finance the balance sheet build and debt service (risks with cash overdrafts), then after taxes are paid there will be minimal distributions to finance any indebtedness on an equity interest purchased. A novice buyer who omits appropriate valuation analysis in such will achieve the proverbial coal miner’s lyrics “You shovel sixteen tons, and what do you get? Another day older and deeper in debt”.

Novice approaches to valuation including simple multiples of earnings for goodwill and rules of thumb on equity valuation will ultimately result in variable failures of expectations for the impulsive. If the impulsive is a seller, missed expectations can lead to a bargain for the buyer and a forfeited upside on a realistic ROI. Often in that instance, the concerns are less problematic because the seller never realizes what is forfeited in value, while the buyer reaps substantial ROI. More concerning for a buyer, it is much more problematic when expectations fail – missed payments on debt-financed acquisition costs or cash flow shortages. When combined with personal guarantees the stakes are high. The definition of bankruptcy is as real and unchanged (as of today) as it was in the days of the Charles Dickens novels.

To summarize: As in any profession, retaining the expertise of a highly skilled and trusted advisor, say valuation analyst in this regard, is not just good advice. It is sage advice. Listening to the prepared testimony (prophecy) of an experienced valuation analyst’s opinion is highly advised for any transition plan. If you or a fellow business friend are planning or preparing to plan a transition of your business whether, in whole or in part, you are advised to retain the services of a trusted (unbiased and objective) valuation analyst. Beginning a business transition with the right expectations (i.e. a great valuation prophecy) will make the pathway easier and smoother for all parties.

Business Valuation for Transition – Market Approach

Preface: You see [value] more creatively when you look at the world with other leaders who have different backgrounds and experiences. — Bill Taylor from The Best Leaders See Things That Others Don’t.

Business Valuation for Transition – Market Approach

A market approach to valuation is an analysis process that estimates a business value with a comparison of a business interest being analyzed to similar transactions of businesses that have sold on the marketplace with comparable company characteristics. The two primary methods of the market approach to valuation are guideline public companies and guideline transactions such as BIZCOMPS. BIZCOMPS is a detailed online database of private small company transactions. It is the most thorough and accurate resource for financial details on “Main Street” private small businesses.

With market comparisons, a valuation analyst can contrast similar small business transactions with a seller’s discretionary earnings or sales multiples. The seller’s discretionary earnings are a business income before taxes, non-cash expenses such as depreciation, non-operating expenses such as loan interest, and extraordinary expenses and owner’s salaries. The seller’s discretionary earnings differ from EBITDA in that it also adds back the owner’s salaries and certain discretionary expenses on the profit and loss statement.

To estimate a business value with seller discretionary income, a valuation analyst must first calculate the obtain an accurate seller discretionary income amount. Once having completed that math, the analyst then analyzes the valuation metrics from a guideline market comparison to find the best comparable for a business valuation estimate.

The sellers’ discretionary earnings are then multiplied by the corresponding multiple or average multiple for an estimate of value. For example, a business with seller discretionary earnings of $400,000 including net profits of $125,000, depreciation expense of $175,000, owner’s salary of $75,000, and interest of $25,000 may have a multiple of Seller discretionary earnings of 2.5. The value estimate would therefore be one million dollars in that example. Multiples for sellers’ discretionary earnings vary from both industries and businesses. The market approach is often a guide for valuation reasonableness when using an asset or income approach to valuation.

A multiple-of-sales approach is more straightforward with a calculation of a business value based solely on top-line sales revenues. For example, a transaction database may show a business value ranging from .40 to .55 of topline sales. So a valuation analyst would look first at the range of sale multiples represented for the industry and then select the most alike transactions to zoom in and calculate a value estimate.

A business with sales of $2,500,000 with a .42 sales multiple would be worth an estimated $1,050,000 from a marketplace approach estimate for instance. Market approaches are facilitated with standard valuation libraries. Any business valuation that does not include at least consideration of market transactions is increasingly subject to analysts’ bias and opinion and therefore more subject to error. An example is a rule of thumb calculation that a business is worth a certain multiple of sales.

Each business is unique, and a proper estimate of business value will incorporate and consider the uniqueness of a business in a value estimate. For instance, if someone gives a valuator a businesses topline sales and net profits a marketplace analyst an estimate may be possible, but market approaches don’t provide all key characteristics such as key customers, location, networks, and other competitive edge approaches that are safeguards to premiums or discounts on valuation estimates.

A valuation analyst also makes a prophecy of sorts about the future value of the future cash flows of a business when preparing an estimate of value whether a calculation of value or a conclusion of value. Again, no two businesses are identical. Therefore, while using market approaches as a quantitative process as a check of reasonableness with a small business transaction is highly advised, more importantly, is the qualitative and cumulative sage expertise, knowledge, and experience of the valuation analyst preparing the valuation estimate.

….to be continued….


Business Valuations For Transition

Preface : Businessmen shepherd net-worth. Teachers shepherd self-worth.                -Anonymous

Business Valuations For Transition

For more than two decades Andrew had been spending his time as a small business owner. His side hobby of auto repair gigs had grown into a full-scale auto service center with a twelve-bay garage including space for RVs and large truck service and repairs. Andrews Auto had a team of 10 employees that far exceeded his initial vision of helping keep vehicles in great driving condition in his community.

Most days, Andrew watched his management team keep the business running like a Swiss watch while he drove around town running errands and talking with locals at the café. He enjoyed every moment of the opportunity to grow his business and now is thinking about his approaching retirement. That includes cashing in on his cumulative years of toiling to keep up with his business opportunities and growing his business investment. Andrew decided to advertise his business on the marketplace for three million dollars himself. After all, he built the business, so why would he need someone to help him sell it?

Following several months of waiting for an interested bid, a potentially interested party texted him with an offer for $1.0m. The bidder said his offer was fair based on Andrews Auto’s annual seller’s discretionary earnings of $500,000. Andrew never betted that selling a business could be this challenging.

All too often small business owners don’t obtain the experience of a trusted advisor when beginning the process of selling their business, resulting in problematic and unrealistic expectations. This can create unnecessary challenges in the process for both sellers and buyers. Secondly, often small business owners don’t know what they don’t know about the business transitional process, and proper preparation for a business sale or transition is paramount for a truly successful transaction for any business owner.

Planning the sale of a business should begin years in advance. Starting with the end in mind is the best advice. Pastors would agree too, that is a best practices policy for life. Usually, business planning involves benchmarking the estimated value of your enterprise. Well-written attorney-prepared buy | sell agreements have periodic business valuation requirements to set benchmark valuation precedents for owners. The purpose of business valuation as a process to assign economic value to an enterprise is to give business owners an objective estimate of value for their enterprise for whatever the intended purpose.

When your business needs a valuation estimate, whether for benchmarking value or planning a transition, there are three approaches to consider. 1) Asset-based approach. 2) Market-based approach. 3) Income-based approach. An expert business valuation will include at least two of the three valuation approaches in the valuation analysis and estimate process.

An asset-based approach adds up all the assets of the company on its balance sheet. For a going concern-based approach, where the business is to continue as an operating business this valuation calculation includes adding up all assets and subtracting liabilities. A liquidation asset-based approach is used when a business owner is looking to liquidate the assets of a business, whether at a public auction or a liquidator. Asset-based approaches usually result in greatest bargain level business value of the three approaches.

….to be continued…


Commonly Missed Business Tax Deductions

Preface: People rarely succeed unless they have fun in what they are doing.” -Dale Carnegie

Commonly Missed Business Tax Deductions

Many business taxpayers fail to deduct otherwise eligible business expenses or fail to fully deduct qualifying business expenses. As a result, millions of dollars are overpaid to the Internal Revenue Service every year. Below is a listing of commonly missed deductions or deductions that you may not be fully utilizing. You may wish to carefully examine your records to determine if you may be missing any of these deductions.

Home Office Deduction: If you use part of your home as a home office, you may be entitled to deduct expenses related to the home office based on the percentage of square footage the home office occupies. Related expenses include mortgage interest, property taxes, utilities, and repairs, etc.
General Business Expenses: If you use your personal funds for business expenses such as office supplies, these are qualifying business expenses, which you may deduct.

Imputed Interest on Shareholder Loans: If you have loaned money to your business, you are required to charge interest on the loan or interest will be imputed to you. While you are required to report the interest as income on your personal return, your business is permitted a deduction for the interest paid. If any of the interest amount is improperly characterized as wage income to you, your business may be overstating its employment tax liability. By recharacterizing these amounts as interest expense, your business may be able to reduce its employment taxes and possibly obtain a refund.

Meal Expenses: Business meal expenses that you pay with your personal funds may qualify as a business deduction, subject to limitations.
Personal Assets Converted to Business Use: If you have contributed personal assets, such as a computer, the fair market value of these assets qualify as a business deduction, subject to depreciation limitations, beginning with the date of conversion.

Self-Employed Health Insurance: As a self-employed taxpayer, you may deduct 100 percent of health insurance premiums for you, your spouse and your children. The deduction may also include eligible long-term care premiums for a long-term care insurance contract.
Communications Expenses: Expenses related to the business use of your personal telephones, cellular phones, and internet connections may be deducted.

Automobile Expenses: Mileage and other related automobile expenses may be deducted when your personal vehicle is used for business purposes.
Note that miscellaneous itemized deductions that are subject to the two-percent-of-AGI limit are temporarily repealed for tax years beginning after 2017, and before 2026.

If after examining your records you feel that you have missed some qualifying business deductions or if you have any questions about your business deductions or whether certain expenses qualify as business deductions, please contact our office at your convenience.