Viewpoint on Value
How valuators facilitate
Taking a closer look at financial
The early bird wins the case
Get appraisers involved in
litigation sooner rather than later
A little bit of growth is a big deal
How valuators facilitate
ome private business owners make major
decisions by relying on gut instinct, rather
Accounting payback is perhaps the most common —
than financial metrics. But investments made
and basic — way to evaluate investment decisions. For
on a “hunch” often fall short of management’s
example, a piece of equipment that costs $100,000 and
generates an additional gross margin of $25,000 per
year has an accounting payback period of four years
Being strategic about strategy
($100,000 divided by $25,000).
There’s more to capital budgeting than deciding
which piece of equipment or real estate to purchase.
But this oversimplified metric ignores a key ingredi-
Business owners also might want to ask:
ent in the decision-making process: the time value
of money. And accounting payback can be harder to
calculate when cash flows vary over time.
Should we launch a new product (or discontinue
an unprofitable one)?
Discounted cash flow (DCF) metrics solve these short-
comings. So valuators, who use DCF techniques regu-
Should we make a component in-house (or out-
larly when appraising business interests, are the logical
source production to a third party)?
go-to advisors when evaluating investment decisions.
(See “What’s the business worth?” on page 3.)
Should we buy our equipment (or lease)?
Should we merge with a competitor (or possibly
Net present value (NPV) measures how much value a
capital investment adds to the business. To estimate
go with a joint venture)?
Ultimately, management is attempting to
answer a simple question: If the company
buys a given asset, will the asset’s benefits
be greater than its cost? In addition, they
should determine which growth plans to
pursue first and which to postpone until
funds become available.
Often companies have limited funds and
can’t pursue every investment opportu-
nity. When a financial professional helps
an owner manage the decision-making
process, department managers are less
likely to claim that the owner made his
or her choice based on favoritism or gut
instinct. A more “scientific” approach
improves the chances that others will buy
in on the decision.
NPV, valuators forecast how much cash inflow and
variables change. And they can project multiple
outflow a project will generate over time. Then they
scenarios — such as worst, best or most likely — to
discount each period’s expected net cash flows to its
help management allocate investment funds.
current market value, using the company’s cost of
capital or a rate commensurate with the project’s risk.
In addition, because not all factors in decision-
In general, projects that generate an NPV greater
making are quantitative, presenting the alternatives
than zero are worth pursuing.
in a decision matrix (see “Decision matrix” below)
can be helpful. The matrix weighs both quantitative
Internal rate of return (IRR) is another metric that
and qualitative factors that matter most to manage-
accounts for the time value of money. A valuator uses it
ment and rates each project based on how well it
to estimate a single rate of return that summarizes the
achieves those priorities. The project with the highest
investment opportunity. Most companies have a prede-
weighted score is the better choice.
termined “hurdle rate” that an investment must exceed
to justify pursuing it. Often the hurdle rate equals the
company’s overall cost of capital — but not always.
Valuators can’t guarantee that a project will succeed,
but they can introduce discipline, objectivity and
Other financial analyses
practicality to the decision-making process. In turn,
Valuators can dig deeper than accounting payback
this can help management rein in unrealistic projec-
period, NPV and IRR. They also can perform sensi-
tions and make optimal choices in today’s volatile
tivity analyses to see how the outcome differs if key
What’s the business worth?
Aside from helping management decide where to spend its capital budget, valuators can help
management understand how much the business is currently worth. Many owners have unrealistic
expectations, especially since the latest recession disrupted many industries.
Knowing what the business is worth helps owners devise their long-term investment strategy. If their
company isn’t worth as much as they expected, investors may decide to hold on to their interests
longer to give the market a chance to recuperate. Or they might decide to sell now, rather than allow
business value to depreciate further, if management doesn’t think things will turn around.
Sometimes owners want a
formal appraisal. These can
be valuable if owners have
another purpose in mind,
such as estate planning or
revising a buy-sell agreement.
% Market share
Other times owners prefer
valuators perform limited
procedures or don’t issue
formal written reports. For
example, management might
ask for just a list of recent
Owners’ stress level
and a calculation of median
pricing multiples to assess
Each factor is rated from 1 (highly unfavorable) to 5 (highly favorable). The more
advantageous choice is the investment with the higher weighted score.
Taking a closer look at
financial statement adjustments
ever take a company’s financial statements at
face value. Often, an appraiser needs to make
adjustments to get a clearer picture of an
investment’s future economic benefits and to deter-
mine an objective value for the subject interest.
Consider Bon Appétit Café. When owners Joan and
Jonah Jones were getting divorced, they couldn’t agree
on the value of this (hypothetical) French bistro. Both
hired appraisers who agreed to use a 33% capitaliza-
tion rate, based on the restaurant’s condition, location
and operating history. But they couldn’t agree on the
future economic benefits to capitalize.
Joan hired the company’s tax preparer as her
appraiser. He accepted the financial statements at
face value and projected $150,000 of equity net cash
flows for 2014, based on amounts reported on the
2013 financial statements. His value was approxi-
mately $455,000 ($150,000 divided by 33%). So,
Joan asked Jonah to buy out her interest for $227,500
debiting cash (or credit card receivables). But the
(one-half of $455,000).
Joneses had gotten into the occasional habit of pock-
eting cash receipts. While this inadvisable practice is
So, should Jonah buy out her interest for $227,500?
illegal (because it understates taxable income), small
The answer depends on whether that number accu-
restaurant owners do sometimes take this shortcut.
rately reflects what a hypothetical prospective buyer
could expect to earn from the bistro. But it’s likely
Based on documentation furnished by manage-
the number will change — based on necessary finan-
ment, Jonah’s expert estimated that the Joneses skim
cial statement adjustments to account for that par-
approximately $11,000 annually and increased the
ticular business’s situation and circumstances.
restaurant’s 2014 projected cash flows accordingly.
Nonstandard accounting practices
An appraiser determines value by using pricing mul-
Sometimes future performance deviates from historic
tiples and rates of return derived from comparables.
performance. An appraiser might need to strip non-
Thus, if the business deviates from how the compa-
recurring or extraordinary items from the financial
rables generally report transactions, he or she may
statements to normalize the economic benefits
need to make adjustments. Examples of accounting
stream. Examples of extraordinary income and
practice adjustments include differences in inventory,
expenses might include start-up fees, pending litiga-
depreciation or revenue recognition methods.
tion, discontinued business lines or capital losses.
The appraiser also adjusts for nonoperating assets
For instance, when customers pay, most restau-
and liabilities, such as marketable securities, real
rants record the transactions by crediting sales and
estate and shareholder loans.
In 2013, Bon Appétit Café was closed for remodeling
Joan’s parents own the strip mall where Bon Appétit
for two of its slower months. Jonah’s expert added
Café has been located for ten years. No lease has
$10,000 to reflect the incremental cash flows the bis-
ever been signed, and it’s likely that Joan’s parents
tro would have earned during its two-month hiatus.
will raise the rent after the divorce becomes final. So,
In addition, he added back $2,000 of nonrecurring
Jonah’s expert reduced the bistro’s 2014 projected
cash flows by $45,000 to reflect market rental rates
(that is, fair rental value).
Net effect on value
The requisite adjustments
The result of these adjustments — adding back
$11,000 for unreported cash receipts and $12,000 for
vary depending on the
nonrecurring remodeling adjustments and subtract-
ing $45,000 for below-market rent — is a projected
characteristics of the business,
net cash flow of $128,000 for 2014. This equates to
the business interest size
a value of approximately $388,000 — about $67,000
less than that of Joan’s expert. So, Jonah countered
and the valuation purpose.
with an offer of $194,000.
This fictitious example shows that, while financial
Controlling owners make key decisions about dis-
statements are excellent for accounting purposes,
cretionary spending items, such as hiring employees,
they don’t necessarily accurately reflect value — as
choosing vendors and paying dividends. When valu-
is. The requisite adjustments vary depending on the
ing a controlling interest, the appraiser may need to
characteristics of the business, the business interest
adjust financial statements for discretionary spending
size and the valuation purpose. A credentialed, expe-
to more accurately reflect the economic benefits to a
rienced valuator can help you make the right adjust-
ments for your situation. l
The early bird wins the case
Get appraisers involved in litigation sooner rather than later
ppraisers can be invaluable and essential expert
Ask if he or she belongs to any business valuation
witnesses, as you know. But they can help your
professional organizations — and if so, whether he or
case even more if you engage them from the
she possesses business valuation credentials. It’s also
beginning — as soon as deposition questioning starts. A
a good idea to ascertain the valuator’s years of expe-
qualified valuation expert can facilitate questioning both
rience as well as his or her level of familiarity with
in deposition and at trial. Here’s some advice on how to
the subject company’s industry. Look for those who
ensure you get the most out of your valuation experts.
make valuation their top priority and have relevant
Choose the best
In addition, ask whether your potential appraiser spe-
When choosing a business valuator, you want the
cializes in a particular valuation niche. For example,
best, so you need to assess the expert’s qualifications.
owners will deny access to the company’s facilities or
personnel — and, thus, fail to ask for it.
Assumptions and limiting conditions. Most
appraisal reports contain an appendix that lists all
of the valuator’s major assumptions and limitations.
Your valuation expert can help you scour this state-
ment for any red flags, such as a scope limitation,
overreliance on management-prepared spreadsheets,
or the valuator’s (or the valuation firm’s) ongoing
financial interest in the client’s business. These ele-
ments may introduce an element of uncertainty in the
expert’s case or expose potential conflicts of interest.
Get a second opinion
For more help, consider hiring a second valuation
expert to act as a consultant. Your primary valuation
expert can’t act as an advocate for a client’s financial
interests. To do so would compromise his or her per-
someone who works primarily for nonmonied spouses
Most appraisal reports
in divorce cases might be perceived as a hired gun.
contain an appendix that
Ask the right questions
lists all of the valuator’s
Every valuation assignment is unique, but attorneys
can frame deposition and trial questions around cer-
major assumptions and
tain common denominators. Your appraiser can help
you look into any potential weaknesses in the oppos-
ing expert’s background and expertise, such as:
Basic business valuation. The appraiser might sug-
gest giving the opposing expert a pop quiz on valuation
But a disinterested consultant can review both experts’
basics. Obviously, he or she should be able to define
reports and help draft targeted deposition and trial
fair market value and know the three approaches (cost,
questions. In addition, the second valuator can high-
market and income) to valuing a business.
light the strengths and weaknesses in both reports. But
the best part is that a consultant’s work product is pro-
Hesitation and mistakes may indicate that the expert is
tected by attorney-client privilege, which means you’re
unprepared or unqualified. If the mistakes are significant
free to discuss and promote case strategy.
enough, a Daubert challenge may be a viable option.
Valuation process. Determining whether an oppos-
Catch the worm
ing expert followed all the routine steps required to
The more information you have — and the earlier
value the business is key. For example, ask whether
you have it — concerning your valuation expert (and
he or she conducted a site visit and interviewed man-
the opposing expert), the better able you’ll be to craft
agement. If not, ask why. Some experts may sidestep
a winning strategy. Obtaining clarification up front
these procedures to reduce expenses. In adversarial
can help you take full advantage of your valuators’
situations, experts sometimes simply assume controlling
expertise — and ensure a successful outcome. l
A little bit of growth is a big deal
hen valuators use the income approach,
expected to only keep pace with inflation into perpe-
long-term sustainable growth is an impor-
tuity, the long-term sustainable growth should theo-
tant assumption. That’s because a small dif-
retically equal the expected rate of inflation.
ference in the projected growth rate can have a big
impact on business value.
But if real growth is expected — beyond that of the
overall market — the company may warrant a long-
Why growth assumptions matter
term sustainable growth rate above the GDP and
CPI metrics the government publishes. But some
Here’s a simplified example of why long-term sus-
companies in declining industries or generating
tainable growth rates matter. Suppose an appraiser
income from wasting assets (such as oil, gas or coal
values a business at $6.5 million as of Dec. 31, 2013,
reserves) may warrant a lower long-term sustainable
using the capitalization of earnings method.
Let’s look at the math underlying this value. The
company’s normalized cash flows were $1 million
What you can do
in 2013. The valuator estimates the cost of capital
Whenever a valuator makes assumptions about
at 20% and the long-term sustainable growth rate
expected growth, ask yourself whether it makes
at 4%. Using the Gordon Growth Model, expected
sense compared with other economic indicators.
cash flows in 2014 are $1.04 million ($1 million
Companies typically can’t sustain extremely
times 104%) and the capitalization rate is 16%
high growth rates into perpetuity. l
(20% minus 4%). Therefore, the company’s value
is $6.5 million ($1.04 million divided by 16%).
But, what if the appraiser used a 3% long-term sus-
tainable growth rate instead? Then the value would
be approximately $6.1 million ($1.03 million divided
by 17%). Here, a 1% difference in the long-term
sustainable growth rate translates into a difference in
business value of more than $400,000.
How growth rates measure up
One benchmark for long-term growth is The
Livingston Survey, published by the Federal Reserve
Bank of Philadelphia. As of June 2013, the survey
reports that its long-term outlook for real gross
domestic product (GDP) growth for the next ten
years is 2.6%. The Consumer Price Index (CPI) is
expected to grow by 2.5% over the same period.
When reviewing an appraisal, ask yourself: Does the
valuator’s assumption make sense in light of gov-
ernment statistics? Because inflation
is factored into the cost of capital,
valuators also include the rate of
inflation in their long-term sustain-
able growth rates. If a company is
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other
professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In
addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2014 VVma14
John M. Leask II CPA, LLC.
Business Valuation Services
PERMIT NO. 57
765 Post Road, Fairfield, Connecticut 06824
John M. Leask II (Mac), CPA/ABV, CVA, values 25 to 50 businesses annually. Often, Mac’s valuations,
oral or written, are compiled in conjunction with the purchase or sale of a business, to assist shareholders
prepare buy/sell agreements, or to set values when shareholders purchase the interest of a retiring share-
holder. Here are examples:
• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses
by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to
closing and/or helps structure and secure financing. Services have included, but are not limited to,
verifying liabilities and assets, reviewing sales and expense records, and identifying critical issues
relating to future success, and helping management plan future operations.
• Family Limited Liability Partnerships, Companies & Closely Held Businesses. Mac regularly values
various sized business interests for estate and gift tax purposes. He provides assistance to estate and trust
experts during audits of reports prepared by other valuators.
Mac also helps business owners and their CPAs and/or lawyers in the following ways:
• Planning — prior to buying or selling the business
• Prepare valuation reports in conjunction with filing estate and gift tax returns
• Plan buy/sell agreements and suggest financing arrangements
• Expert witness in divorce & shareholder disputes
John M. Leask II CPA, LLC.
• Support charitable contributions
Business Valuation Services
• Document value prior to sale of charitable entities
• Assist during IRS audits involving other valuators’ reports
• Succession planning
• Prepare valuation reports in conjunction with pre-nuptial agreements
• Understanding firm operations & improving firm profitability
More information about the firm’s valuation services (including case studies) may be found at www.LeaskBV.com.
To schedule an individual consultation or to discuss any other points of interest, Mac may be reached at 203 – 255 – 3805.
The fax is 203 – 380 – 1289, and e-mail is Mac@LeaskBV.Com.
If you have a business valuation problem, Mac is always available to discuss your options — at no charge.