Facts and figures you need before closing - John M. Leask II CPA/ABV, CVA

Viewpoint on Value
May/June 2014
Facts and figures you
need before closing
Valuators minimize stress
on both sides of the deal
Key people: Hard acts to
follow, hard risks to measure
5 steps to valuing a business
How excess earnings fits
into an appraiser’s toolkit
E-mail: Mac@LeaskBV.Com
Facts and figures you
need before closing
Valuators minimize stress on both sides of the deal
n appraisal can be useful when you’re planning
Or the combined entity may increase sales volume
to buy or sell a business. Both sides of the deal
by reducing prices to pass along synergy-related cost
may have unrealistic expectations — and the
savings to customers.
use of a valuation professional brings some objectivity
and concrete transaction data to the negotiating table.
Some buyers will share a portion of their synergies
with the seller in exchange for financing, ongoing par-
ticipation from the seller or other desirable deal terms.
Differentiating strategic value
A seller that operates in a technical niche or foreign
An appraisal can provide meaningful insight to
market is in a strong negotiating position, for example.
company insiders. It can help the seller set the ask-
ing price or evaluate whether unsolicited purchase
offers seem reasonable. But valuators typically cau-
Allocating value
tion against sharing this information with prospective
Business combinations require another value-related
buyers, because it could leak proprietary information
consideration: The parties need to allocate the pur-
to competitors. Sharing appraisals could also limit
chase price for book and tax purposes. These alloca-
how much buyers will offer and how much lenders
tions start by computing a cash-equivalent purchase
will finance.
price if a portion of the deal is contingent on future
earnings or if noncash consideration (such as stock in
Most appraisal assignments call for “fair market value,”
the combined entity) changes hands.
which is essentially the price that well-informed buyers
and sellers would agree to buy or sell the business for.
Next, all the tangible and intangible assets acquired
In mergers and acquisitions, a more relevant standard
and liabilities assumed must be identified. Many of
of value is “strategic value.” That’s the price specific to
a company’s most valuable assets aren’t on the bal-
a particular buyer or seller.
ance sheet, unless the seller had previously purchased
Valuing synergies
If a buyer can achieve synergies from a
transaction, it may be willing to pay a
premium above fair market value. Most
synergies are buyer-specific.
Valuators can help both buyers and
sellers put a price tag on synergies.
Economies of scale are the most obvi-
ous type of synergy. Two companies,
once merged, can achieve greater nego-
tiating power with suppliers and con-
solidate overhead expenses.
A business combination can also
increase revenues through cross-selling
opportunities between the two entities.
them from a third party. Accounting Standards
Companies that follow Generally Accepted
Codification (ASC) 805 provides a list of intangible
Accounting Principles (GAAP) classify goodwill as
assets, including patents, customer lists, trademarks,
an indefinite-lived asset that’s subject to impairment
domain names and copyrights.
testing, rather than amortization. But the Financial
Accounting Standards Board (FASB) recently issued
an Accounting Standards Update (ASU 2014-02) that
outlines amendments simplifying how private firms
FASB recently issued
report goodwill.
an Accounting Standards
In a nutshell, FASB now gives eligible private com-
Update that outlines
panies the option to amortize goodwill straight-line,
over a period of 10 years (or possibly less if the com-
amendments simplifying
pany can justify a shorter useful life), and test for
impairment only when a triggering event — such as
how private firms report
the loss of a major customer or supplier — occurs.
Helping both parties succeed
Valuators can help buyers and sellers throughout the
Assigning value to working capital items is usually a
merger and acquisition process. But these assign-
matter of transferring book value from one company
ments require a different mindset and specialized
to the next. But other assets — such as equipment,
skills. Do-it-yourself valuations may result in unre-
real estate and intangibles — often require outside
alistic synergistic expectations. They also can lead to
appraisals. What’s left over after assigning value
postmerger tax investigations and impairment write-
to tangible assets, identifiable intangible assets and
offs due to inaccurate purchase price allocations. l
liabilities is booked to goodwill.
What’s for sale: Stock or assets?
In an asset sale, the buyer cherry-picks assets and liabilities, renegotiates contracts and loans, and
applies for new licenses, titles and permits. In a stock sale, shares of stock transfer to the buyer, and
the business continues to operate uninterrupted. In general, buyers prefer to buy assets, while sellers
prefer to sell stock.
Buyers generally don’t like to assume all of the seller’s liabilities. They also want a fresh start in
depreciating their purchases to reduce taxable income. In an asset sale, the buyer allocates the
purchase price to equipment, buildings and other assets. Then acquired long-term assets are
depreciated over their useful lives.
Conversely, if the buyer purchases stock, it assumes the seller’s basis in the corporation’s assets. After
years of depreciation, the seller’s basis in an asset may be significantly below its fair market value.
Sellers typically prefer selling stock because shareholders’ proceeds are generally taxed at long-term
capital gains tax rates, which are lower than ordinary income-tax rates. Sellers pay more tax on asset sales,
because these proceeds are typically taxed as a combination of ordinary income and capital gains.
Asset sales also can result in double taxation for C corporation sellers. The corporation first pays tax on
any gains from the asset sale. Then the corporation’s shareholders pay tax (again) on their gains when
the corporation is liquidated. In some cases, it’s possible to defer personal-level tax by having the
corporation hold and invest the sale proceeds, however.
Key people: Hard acts to
follow, hard risks to measure
o one is indispensable. But filling the shoes
of a founder, visionary or rainmaker that
unexpectedly leaves a business is sometimes
challenging. The loss of such a “key person” could
disrupt day-to-day operations, alarm customers, lend-
ers and suppliers, and drain working capital reserves.
Consider the stock price fluctuations that Apple has
experienced following the death of innovator Steve
Jobs in 2011. Apple possesses a well-trained, innova-
tive workforce, a backlog of groundbreaking technol-
ogy and significant capital to continue to prosper.
But other businesses aren’t so lucky. Some small
firms take years to fully recover from the sudden loss
of a key person.
Factors to consider
Key people provide value in different ways, depend-
ing on the roles they play in their businesses. So
valuators may inquire about the key person’s duties,
training, experience and contribution to annual sales.
Other factors valuators consider when evaluating a
key person discount include:
Replacement candidates
One of the valuator’s most important tasks is to
The nature of the business,
evaluate the ability of others inside the company to
Personal guarantees signed by the key person, and
take over a key person’s responsibilities and relation-
ships in case of death or a departure from the busi-
Management depth and qualifications.
ness. Does existing management have the knowledge,
skills and business acumen needed to fulfill the key
Generally, companies that sell products are better
person’s duties? Does the company have a solid suc-
able to withstand the loss of a key person than are
cession plan in place to smooth the transition?
service businesses. On the other hand, a product-
based company that relies heavily on technology may
If no one internally could take over, the valuator also
be at risk if a key person possesses specialized techni-
needs to look at the external options. This includes
cal knowledge.
estimating the cost of hiring someone with the same
knowledge, skill and business acumen as the key
Personal relationships are also a critical factor. If
customers and suppliers deal primarily with one key
person, they may decide to do business with another
A key person life insurance policy can help the com-
company if that person leaves the company. On the
pany fund a search for a replacement or weather
other hand, it’s easier for a business to retain cus-
a business interruption following the loss of a key
tomer relationships when they’re spread among sev-
person. So, companies with key person life insurance
eral people within the company.
typically warrant a lower discount for this risk factor.
Measurement techniques
However a valuator chooses to quantify the risk of
losing a key person, it’s important not to double-
Valuators generally use one of three methods
count factors or ignore steps the company has taken
to incorporate key person discounts into their
to mitigate key person risks. For example, a business
might purchase disability and life insurance policies
on key people to bridge the temporary cash flow
1. Adjust future earnings to reflect the risk of losing
shortage their departures might cause. A business
a key person,
can also minimize key person risks by implementing
management training programs, succession plans and
2. Adjust the discount or capitalization rate through
long-term contracts with key customers.
the specific company risk adjustment, or
Rare but potentially significant
3. Discount the preliminary value by a certain
Not every business warrants a key person discount.
Most have taken steps to minimize the risks of losing
a key person. But sometimes — especially for small
Quantifying the discount is a challenge because,
businesses with limited operating history and charis-
unlike marketability and minority discounts, there’s
matic, innovative leaders — key person discounts are
little empirical support for across-the-board key per-
son discounts in business valuations.
a real, and potentially significant, possibility. l
5 steps to valuing a business
aluators use a variety of analytical techniques
Premise of value (controlling or minority, market-
and possess different qualifications. But a com-
able or nonmarketable),
mon denominator is the process that everyone
uses to value a business.
Basis of value (as a going concern entity, in
orderly liquidation or forced liquidation), and
1. Retention
Purpose of the appraisal.
The first step to valuing a business or an interest in
a business is retaining an appraiser and agreeing on
For example, you might retain an appraiser to deter-
the price, deliverables and scope of the assignment.
mine the fair market value of a 20% interest in ABC
Typically, the valuator and client sign an engagement
Company as of Dec. 31, 2013, on a minority, non-
letter, which serves as a legally binding contract that
marketable basis as a going concern entity for
helps the parties understand such parameters as the:
estate tax purposes.
Company name,
Engagement letters also confirm the fees.
Expect to sign a revised engagement letter
Percentage or number of shares to appraise,
or an addendum to the original contract if
Effective appraisal date,
the scope of the project changes.
Standard of value (such as fair market value, fair
2. Document requests
value or strategic value),
The valuator will provide a list of docu-
ments that he or she will need to better
The purpose of fieldwork is to see firsthand how the
business operates and ask relevant questions before
the appraiser crunches the numbers. This step is
essential to understanding the risk factors and oppor-
tunities the business faces.
4. Report preparation
Full written reports typically start with
a summary letter, followed by a more
detailed description of the valuation
methodology used and conclusions
made. Appendices may include state-
ments of sources used and key manage-
ment representations, the appraiser’s
curriculum vitae, and numerical exhib-
its that summarize financial analytics.
A survey conducted at the AICPA
Forensic & Valuation Services
Conference in 2013 revealed that the
understand how the business operates. In addition
average length of a business valuation report is cur-
to the last five years’ financial statements and tax
rently about 50 pages. Participants at the recent con-
returns, the expert might request shareholder agree-
ference also reported an increase in the demand for
ments, leases, marketing materials, trade association
shorter “calculation reports.” Although calculation
benchmarks and other relevant documents.
engagements may cost less than full reports, they’re
appropriate only in limited circumstances and gener-
If an appraisal will be used in a legal proceeding,
ally not used for litigation purposes.
involve the valuator in the discovery phase. This is
especially beneficial when you lack access to the com-
5. Expert testimony
pany’s financial records and premises. It’s harder for
An expert’s written report may serve as his or her
a controlling shareholder to deny access if it’s been
direct testimony in tax court. But other courts allow
mandated by the court.
experts to provide direct verbal testimony when they
value a business for other purposes, such as minority
shareholder disputes, economic damages claims and
marital dissolutions.
Calculation engagements
Before appearing in court, most experts ask clients
are appropriate only in
to pay their fees in full, excluding court time. If they
limited circumstances
don’t, the expert could be perceived as a hired gun
who gets paid only if the court rules in his or her cli-
and generally not used for
ent’s favor.
litigation purposes.
When everyone’s
on the same page
When all of the parties know what to expect at each
3. Fieldwork
phase of a valuation project, it makes the process eas-
Next the valuator will visit the company’s facilities
ier for everyone. This awareness promotes collabora-
to conduct site visits and interview management.
tion and timeliness, as well as minimizing potential
This is an integral part of the valuation process, not
surprises, misunderstandings and rework. l
to be overlooked.
How excess earnings fits
into an appraiser’s toolkit
ritics of the excess earnings method call it
Continuing with our example and assuming a 15%
subjective, ambiguous and outdated. IRS
return, the value of intangibles would be $4 mil-
Revenue Ruling 68-609 recommends using it
lion ($600,000 divided by 15%). There’s no specific
“only if there is no better basis available.”
empirical evidence on which to base this rate of
return. Instead, valuators use professional judgment.
Yet the method remains a viable tool, especially when
valuing small professional practices for divorce pur-
Add the parts to value the whole
poses. Because of its perceived simplicity, the excess
The last step is to combine the value of tangible and
earnings method can also serve as a meaningful sanity
intangible assets. In our example, the company’s
check for other methods. Here’s how it works.
value would be $6 million ($2 million of net tangible
assets plus $4 million of intangibles).
Start with tangibles
The first step of the excess earnings method is to
An appraiser can also calculate the overall rate
value the company’s net tangible assets. Book value
of return on assets to use as a sanity check. That
may be a reasonable proxy for some items, but others
requires dividing the company’s normalized earnings
may need to be adjusted.
by its value. For example, $800,000 divided by
$6 million equates to an overall return on assets of
For example, the book value of inventory may
about 13%.
include obsolete or missing items. Fixed assets that
have been fully depreciated may continue to provide
Avoid pitfalls
value. And real estate recorded years earlier at his-
Like any appraisal technique, the excess earnings
toric cost may require an appraisal.
method is only as reliable as its underlying assump-
tions. A valuation professional can help you apply this
Tangible assets generate returns of 8% to 10%,
method correctly and avoid potential pitfalls. l
according to Rev. Rul. 68-609. Valuators decide
what’s appropriate for the subject company, based on
its perceived risk and industry guidelines, if available.
Then they multiply the rate of return by the value of
net tangible assets.
To illustrate: Suppose a business expects to achieve
a 10% return on $2 million of net tangible assets.
That’s $200,000. If the company’s annual earnings
historically have averaged $800,000, its excess earn-
ings from intangible assets would equal $600,000
($800,000 normalized earnings minus $200,000
return on assets).
Impute intangible value
The next step is to value the intangibles. Rev. Rul.
68-609 recommends using a 15% to 20% return,
depending on risk levels. The ruling provides no
guidance about the type of earnings to use, however.
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 VVmj14
John M. Leask II CPA, LLC.
Business Valuation Services
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.
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