Mergers & Acquisitions

Resources: Interviews with Industry Experts

Our goal at Morgan & Westfield is to provide you, our readers, with high quality information and valuable resources to help you navigate through the process of buying or selling your business. In this section, we provide interviews from various professionals somehow involved in the process of buying or selling a business.

Philip Reynolds

Accredited Senior Appraiser and CPA

Today we are interviewing Mr. Philip Reynolds, the owner of First State Valuation Services. Mr. Reynolds has valued companies in various states, including California, Delaware, Georgia, Maryland, Mississippi, Missouri, New York, North Carolina, Pennsylvania, Virginia, and the District of Columbia. In this interview, Mr. Reynolds explains working capital adjustments, equity and enterprise value, buy-sell agreements and how business owners can get a premium value.


Key Points from Our Conversation

  • “The value of a business is equal to the value of the cash flows expected to be generated by the business discounted at a rate sufficient to justify the risk involved in generating those cash flows.”
  • “In addition to knowing how to value a business, qualified business appraisers also know what gives value to the business, so they can suggest what actions to take to increase the value of your particular business before you sell it.”
  • “A minority interest in a business is generally worth less than its pro rata share of the value of the whole business because it lacks the power to control the business.”
  • “A buy-sell agreement is to a business what a will is to an individual: a way to plan for the allocation or disposition of assets or interests in the event of the unthinkable.”

Interview

Tina: How can I get a premium value for my business?

Philip: The value of a business is equal to the value of the cash flows expected to be generated by the business discounted at a rate sufficient to justify the risk involved in generating those cash flows. To increase the value of your business, you can either increase the cash flows that the business is expected to generate, or decrease the perceived level of risk necessary to generate those cash flows, or both.

To increase the anticipated cash flows, you can either increase revenues, decrease expenses, or both. To increase revenues, you can get new contracts, increase marketing, upsell to your existing customers, sell related products or provide related services to your existing customers, increase your hours of operation, or take a variety of other actions. Some business owners reduce the taxes they pay by reporting less revenue than they actually achieve. That may feel good while they are doing it, but it decreases the value of the business when they want to sell it. To maximize the value of your business, you should report all of your revenues.

To decrease expenses, you can discontinue unprofitable product lines or services, get rid of obsolete inventory to reduce carrying costs, stop serving unprofitable customers, reduce hours if those hours are unproductive, or take a variety of other actions. Some business owners reduce the taxes they pay by paying personal expenses or buying personal assets through their business. They may pay themselves or family members for no-show jobs or at excessive rates. Again, that may feel good while they are doing it, but it decreases the value of the business when they want to sell it. To maximize the value of your business, you should keep business and personal accounts separate.

To reduce the perceived level of risk, you can increase confidence in the accuracy of the financial statements . An independent audit provides greater assurance than a review , and an independent review provides greater assurance than a compilation . Even an independent compilation may provide greater assurance than an internal financial statement. Another way to reduce the perceived level of risk is to diversify revenue sources. Try not to rely too heavily on one or a small number of customers for all of your sales.

To increase the value of your business, you can either increase the cash flows that the business is expected to generate, or decrease the perceived level of risk necessary to generate those cash flows, or both

Tina: I am preparing to sell my business within the next year. Can the timing of when I get a valuation affect the "value" of my business?

Philip: Probably not very much. The value of a business is equal to the value of the cash flows expected to be generated by the business discounted at a rate sufficient to justify the risk involved in generating those cash flows. So whatever affects the anticipated cash flows or the level of risk would affect the value.

If you think cash flows may be improving soon, you might want to wait until they do because that might improve the outlook somewhat, which could then increase the value. But if an improvement in cash flows is fairly certain, it should be built into the projections anyway.

If prospective buyers will see the valuation report, then it should probably be as current as possible to give them the greatest possible assurance. That could reduce the perceived level of risk, which would improve the value. So you might want to wait until just a few months before you list the business for sale.

Tina: I am preparing to sell my business and I do not need a full appraisal. Can I hire a business appraiser to just offer me some guidance and help?

Philip: This is a little like asking, “I’m not going to have surgery. Should I still go to the doctor?” Yes, you should probably still go to the doctor. And it would probably still be a good idea to hire a qualified business appraiser. In addition to knowing how to value a business, qualified business appraisers also know what gives value to the business, so they can suggest what actions to take to increase the value of your particular business before you sell it. Also, qualified business appraisers usually have contacts who are business brokers or merger and acquisition professionals, and you may want to speak with them as well.

Notice that I said you should speak with a qualified business appraiser. By qualified business appraiser, I mean a certified business appraiser. There are several professional societies that certify business appraisers. The American Society of Appraisers certifies business appraisers with the designation Accredited Senior Appraiser, or ASA. The designation conferred by the American Institute of Certified Public Accountants is Accredited in Business Valuation, or ABV. And the National Association of Certified Valuation Analysts confers the designation Certified Valuation Analyst, or CVA.

Another organization, the Association for Investment Management and Research, confers the designation Chartered Financial Analyst, or CFA. CFAs tend to be oriented to Wall Street more than to Main Street, and to work for investment firms, but some of them do business valuation of non-public companies as well.

Each of these organizations requires rigorous training before it will confer a designation, so if you see the letters ASA or ABV or CVA or CFA after the name of an accountant or financial analyst, you can be pretty sure that they are qualified. Another professional society called the Institute of Business Appraisers merged with the National Association of Certified Valuation Analysts, but before doing so they conferred the designation Certified in Business Appraisal, or CBA, so you may see that title as well.

Finally, for our Canuck friends in The Great White North, the Canadian Institute of Chartered Business Valuators offers the designation Chartered Business Valuator, or CBV.

By qualified business appraiser, I mean a certified business appraiser.

Tina: I am only going to sell a minority portion of my business. Do I need a valuation?

Philip: It could be helpful. A minority interest in a business is generally worth less than its pro rata share of the value of the whole business because it lacks the power to control the business. A professional appraiser could help to determine the size of the discount in your particular case.

I recall one case in which the owner of a business failed to get professional advice before selling part of his business. He sold a controlling interest, but did so in several minority transactions, then got professional advice to determine how much to ask for the remaining minority position. At that point, he was selling a minority interest, so he was not able to get as much for it as he expected. If he had gotten professional advice earlier, he could have received a lot more for his business.

Tina: What is a Working Capital Adjustment? What happens if the working capital is inadequate? As a buyer, how will this affect the price of the business?

Philip: Every business needs a certain amount of working capital to operate. The amount needed is somewhat subjective, and varies from one industry to another, and from one company to another within the same industry.

If a business does not have enough working capital, then, while valuing it, the appraiser projects an increase in the level of working capital. This Working Capital Adjustment increases the investment needed to bring the business to its peak operating condition and reduces the amount of projected cash flow generated by the business. Because the value of a business is determined by the amount of cash flow it is expected to generate, when you decrease the projected cash flow, you decrease the value of the business.

Think about it from a buyer’s perspective. If the buyer sees that a business he is buying does not have enough working capital, he will realize that, after buying the business, he will have to increase the amount of working capital by adding more cash to the business. By doing so, he will be increasing his investment in the business. But the business is worth only so much to the buyer. If he has to add working capital to the business after buying it, then he will not be willing to pay as much for the business as he otherwise would.

It is a little like buying a house that needs a new roof. If the buyer of the house knows he is going to have to make some repairs, then he is not going to be willing to pay as much for the house.

Some businesses have more than enough working capital. In that case, the appraiser can project a decrease in the level of working capital. This increases the projected cash flow and increases the value of the business.

If a business does not have enough working capital, then, while valuing it, the appraiser projects an increase in the level of working capital.

Tina: What is Equity Value? Is this different than Enterprise Value? Do I need to know this if I am selling my business?

Philip: Enterprise Value is the total value of the business. Equity Value is the value of the owner’s equity in the business, and is equal to the Enterprise Value of the business minus debt.

This is easy to see if you compare owning a business to owning a house. The appraised value of the house is what the house is worth if you own it free and clear of any mortgage. But if there’s a mortgage on the house, then the owner’s equity in the house is equal to the value of the house minus the mortgage.

The Enterprise Value of a business is the total value of the business and can be compared to the appraised value of a house. The Equity Value of the business is the value of the owner’s equity in the business and is equal to the Enterprise Value of the business minus debt. The Equity Value of the business can be compared to the value of the owner’s equity in the house, or the value of the house minus the mortgage.

If prospective buyers will see the valuation report, then it should probably be as current as possible to give them the greatest possible assurance.

Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?

Philip: If I could give just one piece of advice to business owners, it would be that every business owned by two or more partners (or shareholders or members) should have a buy-sell agreement. A buy-sell agreement is to a business what a will is to an individual: a way to plan for the allocation or disposition of assets or interests in the event of the unthinkable.

A buy-sell agreement could be triggered by the death or divorce of a partner to keep the business interest out of the hands of the spouse or children of the deceased or divorcing partner. It could be triggered when a partner quits, retires, or is fired or becomes disabled and is no longer able to work. It could also be triggered in the event of the bankruptcy of a partner to keep the business out of the hands of the bankrupt partner’s creditors.

Everyone thinks they will never have a problem with their partner until the problem occurs, and by then it is probably too late to resolve it by anything other than long, drawn-out, and expensive litigation.

Buy-sell agreements can value a business interest in several different ways, and they are not all created equal. Some agreements simply provide a fixed value for the business interest. It’s quick, cheap, and easy, but it may not reflect the true value of the interest and it probably goes out of date very quickly. The business owners may agree to update the value regularly, but then fail to do so. And if they do update the value, how do they do it? Do they use one of the other approaches, or do they just pull a number out of the air?

Other buy-sell agreements may specify a formula to calculate the value of the business interest. This approach is also quick, cheap, and easy, but there is no formula that can always give the value of any business. If there were such a formula, there would be no need for business appraisers. If this approach is taken, the formula should be specified in words and in algebraic symbols, and an example should be provided in the agreement. This may help to reduce disputes later. Even so, because the formula description may be subject to different interpretations, the agreement should also specify who is to calculate the formula (i.e., the company’s attorney, the company’s CPA, etc.).

In addition to being quick, cheap, and easy to implement and calculate, the fixed value approach and the formula approach also give a fairly predictable result; i.e., the individual partners can estimate an approximate value at any time. This makes estate planning by the partners fairly easy.

Another approach to valuation sometimes seen in buy-sell agreements is what I like to call the Solomon approach. Under this approach, one party to a dispute over value would specify the value of the interest and the other would elect either to buy or to sell at that price. At first, this sounds fair, almost like the Wisdom of Solomon, but on further consideration, one can see problems. For example, if the buy-sell agreement were triggered by the death of one partner, he would be in no position to buy. Or if one partner owns 80% of a business and the other two partners each own 10%, the minority partners might not have the financial ability to buy the larger interest. In either case, the second party would realize whether the first party had to buy or sell and could adjust his own behavior to take advantage of that.

Buy-sell agreements that specify a valuation process are the most expensive to implement, but they are also better than the cheaper alternatives. There are several variations of this approach, one requiring a single appraiser and one which requires two or even three independent appraisers. Under the multiple -appraiser approach, both parties hire an independent appraiser. If their value conclusions are close to each other (say, within 10%), the value is determined to be the average of the two values. If the two values are not close to each other, then the two appraisers together may select a third independent appraiser. This third appraiser may mediate between the first two appraisers, or may choose between the two appraisals, or may conduct his own appraisal. If the third appraiser conducts his own appraisal, the final value could be the conclusion of the third appraiser, or the middle of the three values, or the average of the two closest values, or the average of the three values, or some such amount.

Besides the financial cost, the multiple-appraiser process can take months to complete, while the fixed value method, the formula method, and the Solomon method can all be completed quickly. Each side must choose an appraiser, the two appraisers must each complete their appraisal, and the appraisals must be compared. If necessary, a third appraiser must be selected and complete an appraisal. And finally, a value determination must be made. Also, the partners may have no idea what the value will be because they cannot know what the independent appraisers will conclude. This makes planning difficult or even impossible.

The best approach, the single-appraiser method, is more expensive and time consuming than the fixed-price method, the formula method, and the Solomon method, but less expensive and time consuming than the multiple-appraiser method. Under this method, a single appraiser is hired not by the two parties, but by the company. This reduces both the cost and the time to complete the process when compared to the multiple-appraiser method. To further streamline the process, the appraiser should be selected and named in the buy-sell agreement. That saves the time it would take to choose an appraiser in the event that the buy-sell agreement is triggered. If the appraiser is selected and provides a valuation based on the specific language of the agreement when the buy-sell agreement is adopted, and every year or two thereafter, the value determination would be both more current and predictable enough to allow for easy planning. In that event, the value of an interest would be the value determined in the most recent appraisal.

Business owners might object that annual or biennial appraisals can be expensive, and they are right. But they are far less expensive than litigation.


Philip M. Reynolds’s Bio

Philip M. Reynolds, CPA, ASA
(302) 757 – 5407
preynolds@fsvs.biz
www.fsvs.biz/about

Phil Reynolds has appraised businesses for more than 15 years. During that time, he has valued hundreds of businesses and business interests in a variety of industries with a combined value of well over a billion dollars. He has valued companies ranging from start-ups to companies with revenues of hundreds of millions of dollars. Prior to that, he worked in public accounting for 10 years. Phil attended the University of Delaware where he earned degrees in economics and accounting.

Mr. Reynolds has valued companies in many different states, including California, Delaware, Georgia, Maryland, Mississippi, Missouri, New York, North Carolina, Pennsylvania, and Virginia, and in the District of Columbia. He has valued businesses for many different purposes, including estate and gift tax planning and reporting, divorce and other litigation, employee stock ownership plans (ESOPs), transactions, shareholder disputes, buy-sell agreements, bankruptcy, and litigation support.

A Roadmap to the Successful Sale of Your Business (152 pages)

A Roadmap to the Successful Sale of Your Business (152 pages)

You could spend a lifetime figuring out how to successfully sell your business and still end up confused or clueless. What if you can stop the guesswork and start taking action now?

Read more