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Valuation

Reasonable Compensation

Reasonable Compensation

AUTHOR:  RICK EVANS - CPA, CA, CFF, ABV, CVA, CFE, CPA (CALIFORNIA)

One of the most subjective and discretionary expenses for many small closely held businesses or professional practices is owner compensation. Reasonable compensation is a key assumption in the valuation model as it can have the most impact on the profits of the closely held business. This is due to the fact that compensation recorded in the Company’s books and records and presented in the financial statements is not always at market rates and it is not required to be. For example, owner compensation may have been established for tax planning purposes.

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7 reasons why an up-to-date valuation is an asset to your business

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Author: RICK EVANS, CA, CPA(CA), ABV, CFF, CVA, CFE

Many business owners only obtain a valuation of their business when they are considering a sale, or reacting to an unforeseen situation. But there are benefits to always having an up-to-date valuation in hand. It’s a proactive measure that ensures you are acting from a position of strength when the unexpected does happen.

Here are some reasons why you should have a current valuation of your business:

  1. You are ready if you receive a purchase offer for your business that has to be acted on quickly.
  2. Value changes over time. A business valuation helps you to understand, on a timely basis, the impact of variables such as changes in the economy, your industry, your expense structure and staffing.
  3. A business valuation will highlight areas of strength and weaknesses in your business relative to your industry peers.
  4. Further to points 2 and 3, this gives you the insight you need to take appropriate corrective action.
  5. You understand your capacity to borrow if business opportunities present themselves.
  6. Your business can be quickly put up for sale if family tragedy or other misfortune demands a fast exit.
  7. A valuation can help separate individual goodwill and business goodwill.
  8. Individual goodwill is transferable, if you recognize it and take the time to substitute other people with similar skills and experience into your role.

An up-to-date business valuation prepares you for when opportunities present themselves, helps you understand how to create value in your business and reveals changes in the value of your business over time.

Most importantly, it gives you the power of choice, and protects you from becoming a victim of circumstance when the unexpected happens. An up-to-date business valuation allows you to act in your best interests, as well as those of your family, employees, customers and fellow shareholders.

When tragedy struck, these shareholders were prepared

GoodCase

AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE

In my last post, I presented a case study about Howard, the owner of a successful manufacturing company.

When Howard passed away without a suitable buy-sell clause to ensure an orderly transfer of his ownership interest, all of the business’s stakeholders were caught in the crossfire. These included the other shareholders, his wife and his children.

Today, I have another case study that ends on a more positive note. Why? Because these shareholders did it right at the outset.

Chris and Tom were equal partners and shareholders in an electrical contracting company. When they commenced operations, they instituted a shareholders agreement that included a clear and comprehensive buy/sell clause.

This clause stipulated that, should one shareholder, or his estate, want to sell or transfer their shares in the company, the other shareholder had the right of first refusal. This ensured that no shares would be sold to an unknown third party. It also ensured there would be a market for selling or transferring the shares.

The clause that leaves nothing to chance A key element of a sound buy/sell clause is a defined mechanism for determining how the purchase price of the business’s shares will be determined. In this instance, Chris and Tom had agreed to use the adjusted book value of the company, plus goodwill. Goodwill was defined as one year of the company’s average earnings before interest, taxes, depreciation and amortization (EBITDA).

In addition, the buy/sell clause stated that:

  • The purchase price would be calculated by an independent valuation professional.
  • The valuation report would be paid for by the company.
  • The purchase price would be paid for with life insurance policies on the shareholders that listed the company as the beneficiary.
  • In the event there was not enough insurance in place, the remaining balance of the purchase price would be paid in 60 equal instalments of principal and interest.
  • To insure the partners remained adequately insured to cover the purchase price, a valuation of the company was performed every two years.

Put to the test Tragedy struck after Chris and Tom had been in business for over 20 years.  Tom lost his son in an automobile accident.

The loss had a profound impact on Tom. His focus on, and performance in, the business deteriorated to the point where Chris was bringing in most of the contracts and managing most of the projects.

The partners agreed it was time for Tom to exit the business. Because they had a clear and understandable buy/sell clause, Chris was able to quickly buy Tom’s shares. The only point of contention was the value of some of the machinery and equipment, and they agreed to defer to a valuation by a professional appraiser.

A year after the buyout, Chris decided he didn’t want to be a business owner any longer. With the advice of a valuation expert, Chris spent the next two years marketing the business to potential buyers, and ultimately sold it to a general contractor that had decided to open an electrical contracting division. As part of the deal, Chris was hired as vice-president of that division.

Tom got the quick exit he needed, under fair and equitable terms. Chris, at 52 years old, was able to finance his retirement, budget for his kids’ post-secondary education, and land a new job with the general contractor that paid $200,000 a year.

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In the absence of a buy/sell clause, everyone gets caught in the crossfire

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AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE

In my previous post, I talked about what is arguably the most important, but often most overlooked, component of a shareholder agreement – the buy/sell clause. This mechanism establishes the ground rules for the orderly transfer of an ownership interest.

I’ve seen a lot of unfortunate situations in my work—shareholders who pass away, become ill, succumb to substance abuse, endure personal crises that derail their business focus, or simply fail to fulfill their obligations to their business partners. Without a well-written buy/sell clause, any of these scenarios can cause undue hardship and financial loss for all of a business’s stakeholders.

Take Howard, for example. He is the successful owner of a manufacturing company that makes products using composite technology. He owns 40 per cent of the shares in the company. Three other shareholders each hold 20 per cent.

Howard and his wife have three children. His wife doesn’t work, and depends on the income generated from Howard’s ownership interest in the company.

Then Howard dies, without a buy/sell clause in the shareholder agreement. This leaves his wife with his 40 per cent ownership interest in the company, but she has no intention of actively participating in the operations the company. She needs the proceeds from the sale of Howard’s 40 per cent interest to provide for herself and her children.

The other shareholders don’t want some unknown party acquiring Howard’s shares, but they do not have the funds available to buy Howard’s interest. They also have the added challenge of finding someone with Howard’s expertise to take over his role with the company.

Fifty per cent of the company’s revenue comes from a single customer. Seeing how uncertain the future of the company has become, this customer is considering taking its business elsewhere.

Without this customer, the company’s value could plummet. Employees could be out on the street. The potential loss of value may result in Howard’s wife having to sell her shares for a fraction of what they were worth when Howard was alive.

How much value will Howard’s wife lose? How will this impact her ability to provide for herself and her children?

Now, if there had been a proper buy/sell agreement, it would have:

  • Provided a mechanism for how and when the remaining shareholders could purchase Howard’s shares.
  • Defined how the other shareholders could have funded a purchase of Howard’s shares to ensure liquidity for his wife. Funding is often accomplished through a life insurance policy.
  • Ensured the shareholders would have agreed on the method that would be used to determine the purchase price of the shares.

In my next post, I’ll recount the outcome of a more positive scenario, in which the shareholders did it right from the outset, to their mutual benefit.

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A buy/sell clause helps prevent business divorces from getting messy

ShareholderAgreement

AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE

Business partners set up shop with the best of intentions. It’s a relationship that must be built on mutual trust and respect. But no matter how strong a personal or professional relationship is at the outset, shareholder conflicts and other events may occur that can affect the continuity of the business operations. A mechanism and process that establishes the ground rules for the orderly transfer of the businesses shares caused by unforeseen conflicts or events is important. A suitable buy/sell clause in the shareholder agreement that is understood by the parties is an important tool to ensure this orderly transfer and the continuity of the business operations.

A buy/sell clause is often the most neglected feature of a shareholder agreement, either because it’s set forth in an arbitrary and confusing manner, or because it’s neglected altogether. It can be an uncomfortable subject to raise when fellow shareholders are close friends or family, since it‘s analogous to asking a fiancé to sign a pre-nuptial agreement. However, the lack of a buy/sell clause often results in disputes, costly legal proceedings, long delays in transferring of ownership and disruption in the business operations.

The buy/sell clause provides a mechanism for how and when the remaining shareholders can purchase a departing shareholder’s shares due to a triggering event, such as a shareholder retirement, disability, death or dispute. It also defines how that purchase will be funded to ensure liquidity. Funding is often accomplished through a life insurance policy.

Most importantly, it forces shareholders to agree on the method that will be used to determine the purchase price of the shares Here are some examples of methods used to determine price in a buy/sell agreement:

  • Price is determined by a business valuator.
  • The parties to the agreement negotiate a fixed price and update annually.
  • The price is determined by a formula.
  • Price is determined by a shotgun clause.
  • Price is determined by the right of first refusal.

Each of the methods has its advantages and disadvantages. To determine which is in the best interests of all shareholders, a business valuator should be consulted during the drafting of the buy/sell clause.

In my next two posts, I’ll feature two case studies that put this in perspective.

The first will explore the legal nightmare that arose in a business when a majority of shareholders wanted to force the rest to accept a buyout offer, without the guidance of a buy/sell clause. The second will examine a business that did it right from the outset, and how this ultimately played out to the benefit of all shareholders.

Restaurant woes: Serving up a disappointing retirement outlook

RestaurantWoes

AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE

It seems odd that a business owner would work his or her whole life on their business and then determine the business’s value based on what they “think “the business is worth, or an industry rule of thumb. If the sale of your business is going to fund your retirement you should know what your business is worth.

Mr. Jones, A Quick Service Restaurant owner, has determined (based on industry rules of thumb, and conversations with friends) that restaurants like his are sold for multiples of between one and three times seller’s discretionary earnings (“SDE”), plus fixtures, equipment and inventory. SDE is defined as earnings before interest, taxes, depreciation and amortization, plus owner’s compensation. Mr. Jones knows his average SDE for the past five years has been $300,000. He “knows,” therefore, his business is worth $900,000 plus the value of the fixtures, equipment and inventory of $100,000 (owner estimate), or $1 million. Mr. Jones is 50 years old and has based his retirement plan on the restaurant value of $1 million. Mr. Jones and his wife like to spend money and the restaurant represents over half of their net worth.

A valuation would have determined the following:

  • The restaurant is 20 years old, looks its age and certain equipment needs to be replaced within the next two years.
  • The restaurant does not have a state of the art Point of Sale system (“POS”).
  • The rent being paid for the premises is below market rent. Rent expense is expected to increase significantly when the current term expires. This will reduce SDE in the future.
  • The building that the restaurant operates from has new owners. There is no guarantee that the new owners will want to lease the premises to a restaurant when the current lease term expires in three years.
  • The minimum wage is expected to increase significantly in the next year. This will reduce SDE in the future.
  • Parking available for restaurant patrons is maxed out.
  • Population growth is expected to be two per cent for the next five years and income is expected to grow at two per cent in the same time period.
  • The SDE information is based on the income tax returns prepared by a non-designated accountant.

Contrast the above scenario with another Quick Service Restaurant, with the same SDE and the following circumstances:

  • The financial statements of the company are reviewed by a professionally designated accountant.
  • Management has recently had a valuation report prepared. SDE is taken from this valuation report.
  • The restaurant is located near an NHL arena.
  • Population growth in the next five years is expected to be 15 per cent, and income growth is expected to be eight per cent over the same time period.
  • The restaurant is four years old and has six years left on its lease, with two five-year renewal options.
  • The restaurant’s POS system is new.
  • It is easy to see that if we assume the restaurant in scenario 2 has the characteristics of a restaurant selling at multiples of three times SDE plus the value of the fixtures, equipment and inventory, and we estimate that value to be $1 million, then the value of the restaurant in scenario 1 is significantly less than $1 million. It is likely Mr. Jones restaurant would be worth less than $400,000.

Clearly there is a gap between Mr. Jones’ estimate of the value of his business and the actual value.

  • The first thing Mr. Jones has to do is get the restaurant valued by a valuation professional.
  • He needs to talk to the landlord and determine whether they will renew the lease. If the landlord is not willing to renew the lease, then it is unlikely Mr. Jones will be able to find a buyer.
  • If the lease will not be renewed, Mr. Jones may decide to keep operating the business as is, invest his SDE in investments outside the restaurant and turn the lights off when the lease expires in three years. (1)
  • If the lease will be renewed, Mr. Jones will have to decide if he wants to invest the time and money necessary to maximize the value of the restaurant. Last spring, Ottawa’s Calabria Restaurant in Centretown announced it was closing after 42 years of family operation, after it was given notice by its landlord that its lease would not be renewed. In September 2013, the Mayflower Restaurant on Elgin Street, in Ottawa, also announced it would close, after 35 years, due to lease issues. Mr Jones should be prepared.

Your business may not be worth as much as you think it is...yet

BusinessWorth Do you know how much your business is worth? And by worth, I mean what price it would realize if it was for sale today. Many times small business owners think their business is worth more than it currently is. This is often referred to as the value gap.

If your business represents a significant part of the funding for your retirement, you will want to determine the amount of this gap sooner rather than later.

Some reasons for the value gap:

  • Much of your business value may be due to your expertise, relationships and reputation. Ask yourself this question: Can your cash flows/earnings be replicated in the future without your presence? If not, your business has little value to a purchaser.
  • Profitability may be due to less than market rates being paid for management services, rent, etc.
  • Your financial performance may be below industry averages. Buyers will examine key ratios to see how your business compares to the industry average.
  • Your Company has not kept up with needed capital improvements, and/or repairs and maintenance requirements.
  • You have been relying on rules of thumb or formulas provided by friends or associates.
  • Value changes over time due to changes in economic and industry circumstances.

An up-to-date business valuation will identify the above factors and the amount of the value gap. This is an essential starting point for a successful retirement plan.

An up-to-date valuation will also help in being prepared for unforeseen circumstances such as divorce, death, or shareholder disputes.

Rick Evans is a Chartered Accountant, Certified Public Accountant (CPA-California), Accredited in Business Valuation (ABV), Certified in Financial Forensics (CFF), Certified Valuation Analyst (CVA) and a Certified Fraud Examiner (CFE). Follow McCay Duff LLP on Twitter: @McCayDuffLLP

The Income Approach to Determining Business Value

Post5The income approach is often the primary approach used for valuation and is used in the valuation of most operating companies.

The income approach discounts the expected future cash flows (returns on investment) to present value using an appropriate rate of return for the investment.

Future cash flows are typically based on the net after-tax cash flows expected to be generated by the business.

The discount rate (or rate of return) used should reflect the degree of uncertainty or risk associated with the future returns and returns available from alternative investments. The higher the perceived uncertainty or risk results in a higher expected rate of return, which results in a lower value someone would be willing to pay for the investment.

The two primary methods of the income approach to valuation are the Discounted Cash Flow and Capitalization of Cash Flow Methods.

Discounted Cash Flow Method:

The Discounted Cash Flow method discounts future cash flows to present value using an appropriate discount rate or rate of return. This method is more appropriate when earnings are expected to be materially different in the future, due to changes in factors such as business structure and economic/industry conditions.

Future cash flows are projected for a specified number of years and then projected to grow at a constant rate in perpetuity.  The number of years to use in the projection would be the number of years until the business achieves a sustainable operating level.

An example would be when a business has just completed a major expansion and it is not expected to attain a mature operating level until after three years. At the end of three years a single measure of future cash flows is selected on the basis of the expected stabilized cash flows for use into perpetuity. This is often referred to as the terminal value.

The discount rate is then determined and applied to all future cash flows to determine an estimated value.

 

Capitalization of Cash Flow Method:

The Capitalization of Cash Flow method uses forecasted cash flow for the next period, which is converted to present value using an appropriate capitalization rate.  This rate is equal to the discount rate less the expected growth rate in perpetuity.  This method is often used when a Company’s future operations are not expected to change significantly from its current normalized operations and when future returns are expected to grow at a relatively predictable rate.

This method is also used when the subject company does not have reliable projections.

The forecasted cash flows for the next period are based on prior historical cash flows and the projected cash flows for the next period. The cash flows used should be representative of the expected future performance of the company.

The capitalization rate is applied to forecasted cash flows to estimate value.  In other words forecasted cash flows divided by the capitalization rate equals value.

 

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