value

Higher Business Value Comes from Action

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action

Here are examples of risks in businesses I valued recently. 

Risk

  • The Company has high customer concentration. One customer comprises 80% of sales. If the Company lost this customer, it could go out of business. 
  • There is key person risk embedded in the knowledge, experience, and abilities of the owners that has not been taught to other employees. If any owner dies or becomes disabled, the Company would have difficulty performing critical functions. 
  • The Company has no buy-sell, operating, or other legal agreements. The lack of an agreement directing how issues such as retirement, disability, death, divorce, bankruptcy, quitting, and terminations (among others) should be handled could cause delays, confusion, and shareholder disputes. A dispute that cannot be resolved could put the Company out of business. 
  • No single shareholder can make controlling decisions. This could gridlock the Company when decisions require a legal majority or supermajority.
  • Neither the owners nor the Company owns insurance policies covering the lives of any of the owners. The Company will need to buy out deceased owners with Company assets. This could deplete cash and working capital required for payroll and vendors. 
  • There is no written standby agreement with another company or individuals that could mitigate the effects of losing key people. If enough key people are lost, the Company could go out of business without a backup plan. 

Fortunately, you can take action to solve all these problems.

Action

  • Diversify your customer base. Actively cultivate multiple new customers that can replace the sales of the customer creating the concentration.
  • Train your employees on the knowledge, experience, and abilities of owners and key employees. The book, Traction, has some great examples. A short version is to document your processes using the 80/20 rule and keep it simple.
  • Contact an experienced attorney who can draft and put a buy-sell agreement in place. Review it at least once a year to make sure the provisions are still sound.
  • Put controlling decisions in the hands of fewer owners or create an agreement that provides remedies to make decisions faster while protecting all the owners.
  • Purchase life insurance covering all owners. How this should be structured will be different for every business. It’s good practice to coordinate life insurance with the buy-sell agreement. Be mindful of various income and estate tax provisions you must navigate. You should have a good idea of the value of your business on an ongoing basis so that the life insurance proceeds are sufficient. 
  • Contact companies that could help run or even buy your Company in an emergency. Emergencies could include death or disability of owners or key employees. You can structure formal or informal agreements with a company that could step in if necessary. This can be particularly important if you’re the sole owner and your spouse would have to find someone to run or buy your Company.

Parting Thought

Take action on each of these risks by putting them on your calendar and chipping away one at a time. It will increase the value of your business and even if you decide not to sell, you will sleep better.

Josh Horn, CPA, CVA
Horn Valuation

Sign up for this blog here if you’re interested in business valuation for family business succession and dispute settlement. My clients are business owners and attorneys. You can email me at [email protected] and connect with me here on LinkedIn, Facebook, Twitter, YouTube and Instagram.

“Once-in-a-lifetime events demand an expert.”

Tradeoffs in Business Valuation Settlement

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tradeoffs

I’ve had some success helping owners who wanted to stay out of court over business valuation disputes. There are tradeoffs, however.

The value of a business (simplified) is:

V = CF x (1 + G) /
(R – G)

Where V = Value, CF = Cash Flow, G = Growth, and R = Risk

We solve for “V” by estimating the other three variables. If any one of these happens:

  • Cash Flow (CF) goes up
  • Growth (G) goes up
  • Risk (R) goes down

Value (V) goes up and vice versa.

When all three variables move and in the same value-increasing or value-decreasing direction, the value of the business can really change.

It’s important to understand what tradeoffs you may be accepting to reach a faster settlement out of court. In practical terms,

  • Management interviews are usually limited.
  • Documents reviewed are usually limited.

As a result,

  • Future cash flow could be higher/lower than what is known.
  • Future growth could be higher/lower than what is known.
  • Future risk could be higher/lower than what is known.

Here are examples of needle movers that may be unknown without enough interviews and documents:

  • $1 million in new sales from customers (CF up)
  • $1 million in new equipment purchases needed (CF down)
  • High-demand technology developed (G up)
  • Headed into a down cycle (G down)
  • Owner able to be absent from successful business (R down)
  • One customer comprises 90% of sales (R up)
  • Discounts for lack of control & marketability? (V down)

If you’re an active owner in the business, these needle movers may be known. If you’re a passive investor, living somewhere else, or married to the business owner, they may not. It’s also not unusual for an active owner to know things another active owner does not simply because of division of responsibilities. 

Why Does this Matter?

Here are two examples that show business value ranges when all three variables are changed.

Example 1:

  • Solve for “V” when:
  • CF = $450,000
  • G = 2%
  • R = 25%

$450,000 x (1 + 2%) / (25% – 2%)

= $459,000 / 23%

= $2,000,000 Value

Example 2:

  • Solve for “V” when:
  • CF = $550,000
  • G = 4%
  • R = 18%

$550,000 x (1 + 4%) / (18% – 4%)

= $572,000 / 14%

= $4,000,000 Value

The value of the business doubled and increased by a whopping $2 million!

Parting Thoughts

I am not encouraging you to go to court in every situation. I was hired in cases that went to court that shouldn’t have. The critical point I want to make is you should work with someone like me to estimate the likely highest and lowest values for the business. After a range of values is estimated, you can make an educated determination to accept tradeoffs or push for more information. Sometimes, more information gives my clients enough peace of mind to settle their case. Sometimes, they decide they must go to court. If you’re interested in more information, my webinar, Settling Business Valuation Disputes, is here: https://youtu.be/43xLivwdyOs

Josh Horn, CPA, CVA
Horn Valuation

Sign up for this blog here if you’re interested in business valuation for family business succession and dispute settlement. My clients are business owners and attorneys. You can email me at [email protected] and connect with me here on LinkedIn, Facebook, Twitter, YouTube and Instagram.

“Once-in-a-lifetime events demand an expert.”

How to Speed Up Your Business Valuation

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speed

After, “how much will this cost?”, the second most common question I get is, “how long will this take?” These will speed up your business valuation. 

Close the Books Faster

Even with all the automation tools available today, many businesses take too long to reconcile accounts, close their books, and provide clean financial statements. Work towards closing a few days after a month and year. Sit down with your accounting team and figure out the roadblocks. Too many manual processes? Data everywhere? You may need to…

Upgrade Accounting Software

Many businesses haven’t modernized at this basic level. Software today can be accessed anywhere online, has security protocols, and can create reports your business valuation analyst needs. Your valuation analyst can also remotely access your accounting information and run reports. Without this, they will spend more time at your facility and need more of your valuable time. You’ll be better positioned to…

Digitize Everything

If your systems are mostly paper, it’s time to step up your game. Not only will it slow your business valuation, but you’re more susceptible to fire, flood, and theft risks. Having the ability to produce documents for your analyst in Adobe and Excel will save time. Request that your accountant and attorney provide digital documents so they’ll be easily accessible when you’re ready for a business valuation.

Parting Thoughts

The benefits of this extend to more than business valuation when you want to sell or transfer your business. By closing your books faster using modern accounting software and digital documents, you can increase business value every day because you’ll have data to increase cash flow and reduce risk at your fingertips. Consult with your IT professionals to make sure your data is secure and backed up off site.  

Josh Horn, CPA, CVA
Horn Valuation

Sign up for this blog here if you’re interested in business valuation for family business succession and dispute settlement. My clients are business owners and attorneys. You can email me at [email protected] and connect with me here on LinkedIn, Facebook, Twitter, YouTube and Instagram.

“Once-in-a-lifetime events demand an expert.”

Decisions That Can Distort Business Value

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decisions

Decisions you’re making every day as a controlling owner may give you a false sense of business value. These are ones I often see that you should review.  

Owner Compensation

Most companies I value are corporations. You should be paying yourself W-2 compensation if you’re providing labor and you’re profitable. But, is your salary arm’s length? If you had to hire someone to do what you do, would you have to pay more or less? This may be motivated by payroll and income taxes. In an S corporation, there may be motivation to keep the salary low so that profit can be shifted away from payroll taxes. In a C corporation, there’s usually motivation to keep salary high so that you can avoid double-taxation on dividends. The problem is that tax motivations may not match fair market value. Keep in mind that if the salary should be adjusted up, business value will go down and vice versa. There are multiple sources you can use to estimate an arm’s length salary. 

Rent

It’s common for the business owner to own the building that the operating business uses. It’s usually structured so that the operating business pays rent to the owner or their LLC that separately holds the building outside the operating business. If you’re doing this, when was the last time you reviewed the rent to make sure it’s arm’s length? A real estate appraisal is usually the best way to determine this, but that might not be feasible every year. A suggestion is to have the building appraised every few years and increase or decrease rent in the interim years using updated data. A rent adjustment has the same impact as owner compensation and may also be motivated by taxes. I valued a business a few years ago and the owner was paying himself no rent for the building he also owned. Unfortunately, the business had little value after rent expense was added.

Summary

It’s a good idea to review your financial statements regularly for all expenses that may not be arm’s length. You may need to adjust them up or down and maintain a file supporting your past and ongoing decisions. This will serve the dual purposes of staying in compliance with authorities and making sure you understand the impact on business value. Otherwise, when you’re ready to sell or transfer the business, you could be in for an unwelcome surprise.

Josh Horn, CPA, CVA
Horn Valuation

Sign up for this blog here if you’re interested in business valuation for family business succession and dispute settlement. My clients are business owners and attorneys. You can email me at [email protected] and connect with me here on LinkedIn, Facebook, Twitter, YouTube and Instagram.

“Once-in-a-lifetime events demand an expert.”

Should You Skip a Valuation for an Estate?

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Here’s the scenario. One of your parents dies and they own a business. Should you value the business for their estate? Maybe. I want to lay out the case for giving this a closer look.

Family Disputes

I’ve worked with a lot of executors and trustees, and I’ve seen these:

  • The business is usually one of many assets.
  • The business is often the most difficult asset to value.
  • The business may be the most valuable asset in the estate or it might be worth nothing. 
  • The more beneficiaries, the more likely there will be conflicts.
  • If the business isn’t valued by a professional, someone will guess the value.
  • Guesses lead to fights and mistakes that cost time and money.

A good business appraiser should put value disputes to rest. It will also help you correctly allocate and distribute assets consistent with your family member’s will or trust.

Estate and Income Taxes

While it’s common today for many estates to be under the Federal estate tax exemption and not be required to file a Form 706, state estate or inheritance tax can be another story. You cannot accurately make Federal or state estate tax determinations if you don’t have values for all the assets and liabilities, including the business. The risk from unpaid estate taxes, interest, and penalties usually extends to the beneficiaries indefinitely. That means your personal assets are at risk if the proper filings and payments aren’t made.

Whether the business is retained or sold, income taxes after death are often computed based on the value of the business at death. Stated another way, without a business valuation, you will often be unable to estimate anyone’s tax basis in the business on the date of death. This can become particularly complex if the business is retained by multiple beneficiaries after death. A surviving spouse and children who continue to own the business usually add more complexity.

Parting Thoughts

Hiring a qualified business appraiser will cost money, but it’s important to consider your risks of not hiring one. Consult an attorney and a business appraiser, both with significant business estate experience. This meeting should be conducted with both professionals. After meeting and reviewing documents, they can recommend how to proceed. By the way, it’s a great idea to have these meetings before your business-owning family member passes away. Your family member can then update estate documents to match their wishes before it’s too late.  

Josh Horn, CPA, CVA
Horn Valuation

Sign up for this blog here if you’re interested in business valuation for family business succession and dispute settlement. My clients are business owners and attorneys. You can email me at [email protected] and connect with me here on LinkedIn, Facebook, Twitter, YouTube and Instagram.

“Once-in-a-lifetime events demand an expert.”