Randy Lewis

Randy: If this were the mid-to-late 1990s during the dot-com boom, it would be all about revenue growth. Investors knew the Internet was big so it was all about capturing market share in the theory that earnings would catch up. In fact, it was as if there was something wrong with your model if you were profitable. Since then, there have been several periods of “flights to quality,” meaning there are more important things than revenue, such as scalability and margin improvement. For example, ask yourself, “If I grow revenue, will I be able to provide my product or service more inexpensively?” In other words, buying 100 widgets to sell might cost you $10 a widget, while buying 1000 might cost you $7. This is economies of scale (assuming your selling price does not come down commensurately).

Randy: We value a lot of service businesses, some of which are for sale.

1. Unfortunately, the owner leaving such a business automatically reduces the value most of the time, as these companies are highly relationship and trust-based. Most buyers will assume a certain attrition rate upon purchase.
2. Number two would be a declining market. Think of Blockbuster. The company tried everything to capitalize on new entertainment delivery strategies but was unable to do it. The fact was, a large brick-and-mortar operation like Blockbuster simply could not make a living renting DVDs anymore.
3. The last is lack of any upside. Many buyers want to see a growth opportunity and if your target market is extremely finite, this could affect value.

Randy: If you are lucky you will get paid for the potential of your company. We call this “investment value.” In my opinion savvy buyers should not pay much, if anything, for “potential.” Yet, we all see the business-for-sale listings. All of them allude to the potential of the business. To us, they might as well say: “I can’t make anything of this business, but if you do X, Y and Z, you can.”

Our question to that seller is always, “If X, Y and Z are as easy as you make them sound, why are you not doing it and selling your business?” We realize there are many reasons to sell a business, but why not capture as much of that value as you can? Unfortunately, most sellers do not plan in advance and sell when they are somewhat (or completely) burned out.

If you simply look at accounting earnings ( net income ), you are implicitly incorporating accounting rules that most likely affect value, such as deducting non-cash expenses and certain accrual rules.

Randy: They are certainly reasonable – mostly because everyone uses them. There are many factors that affect value, but efficient market theory suggests that multiples actually paid reflect all of these factors. That is, buyers and sellers know the factors that affect value, even if they cannot always articulate them, and what better gauge of value is there than what they paid?

Many sellers want easy rules of thumb (cannot blame them), but they often do not know what they mean or cannot dig below the numbers to find out what is more or less important. As in real estate appraisal, multiples provide a basis of value and then should be adjusted up or down based on the specific facts and circumstances of the subject business. This is what most business owners do not, or cannot, do.

Also, be careful how you define “earnings.” In appraisal, we call this defining the “benefit stream” which will be used in valuing a business. If you simply look at accounting earnings (net income), you are implicitly incorporating accounting rules that most likely affect value, such as deducting non-cash expenses and certain accrual rules. For example, recording sales that are never collected. Cash flow is almost always a better measure.

Randy: Absolutely not. This is part of what makes capitalism what it is. One challenge appraisers often face is getting clients to stop viewing their business simply as a source of income and start viewing it as an asset. Sources of income are not sold, assets are. The vast majority of businesses in the U.S. are small – making up more than 99% of employers – and are sold or recapitalized all the time.

Randy: “Need” is a strong word, but seller financing typically makes it easier to sell your business. Your level of involvement is really up to you and is dependent on what type of business it is. You certainly want to make sure that payments are made in a timely fashion and the buyer does not default. Also, it depends on what you would consider “long-term.” Though we are not brokers, we have advised sellers on the time commitment they should expect. The financing agreement should be airtight with respect to default. You should expect to back into the business if the buyer defaults, unless you are prepared to just let the business go.

Most of the time, however, the value of intangible assets is derived from the cash flows they produce, which is reflected in other valuation methods.

Randy: Yes we do. There are instances, particularly in financial or tax reporting, where intangible assets need to be valued separately. We just performed a trademark valuation where the owner transferred a trademark to a new entity that he also owned and subsequently will be conducting the same business from the new entity. Most of the time, however, the value of intangible assets is derived from the cash flows they produce, which is reflected in other valuation methods. Therefore, often they are not valued separately.

Randy: Generally, we tell business owners three years. This way, you can start the implementation of any changes and have a track record of improvement. Remember a large part of what you’re selling is your track record. It also gives you time to clean up any records issues (i.e., “books”) to make your business more presentable. The larger the business, the more important this clean-up is. Most business owners fail to recognize how easy it is and how value is added.

To answer the question, if your CPA is not performing the valuation or appraisal, they need not be very involved and you certainly do not have to alert them that you are having your business appraised.

Randy: Many CPAs perform valuations, but as finance professionals and analysts, we find their work wanting some of the time. We can always tell the difference between a valuation done by an “accountant” and one done by a “finance” person. There are great ones, however, as many CPAs bring invaluable tax and business experience to the process. We like to think we bring the best of both worlds.

To answer the question, if your CPA is not performing the valuation or appraisal, they need not be very involved and you certainly do not have to alert them that you are having your business appraised. For us, they are typically just a source of information ( tax returns , QuickBooks files, etc.), however, there are times when they can help shed insight. Also, depending on your relationship with your CPA, there might be a personal reason why you would tell them, but there is often no business reason.

Randy: We do not find this difficult most of the time, as most accountants are not analysts. Unless you direct them differently, a typical CPA has the job of preparing tax returns and related duties to get that job done. A good CPA has the foresight to properly plan for future tax consequences as well. We do not compete with them at this level. A great CPA will also be able to properly analyze a business, compare it to its peers and see how different strategic business elements affect growth, profitability, and ultimately value. Our experience is that the latter is rare. To minimize the potential overlap, we suggest you keep it simple: If your need has the word “tax” in it, then think of your CPA; anything else, think analyst or appraiser.

Randy: They can be useful if put in proper context. Transaction databases provide multiples of value, such as price-to-earnings, price-to-sales, price-to- EBITDA , etc. which can then be compared to your business to establish a value. There are two huge caveats:

1. The first is that there are many factors that affect value. As in real estate appraisal, multiples (comps) provide a basis of value and then have to be adjusted up or down based on the specific facts and circumstances of the subject business.
2. Secondly, there is no database which will provide a perfect picture for your business. In fact, many times, we cannot use this valuation approach at all because of small sample size or lack of acceptable comps altogether. Think about it. If you were selling your house, were trying to price it, and a real estate agent presented you a list of comparable sales from your neighborhood – most of them from 2004 – you would be highly skeptical. It is the same in business appraisal.

So at its worst, you are taking non-comparable, unadjusted numbers and applying them to your business. Your time would be better spent throwing darts at a dartboard.

Randy: Speaking to sellers, focus on your business and let professionals handle what they do best. There is a basic law of economics: everyone should focus on what they do best and most efficiently. Sometimes, all we have is our time – and we need to know how best to spend it (highest and best use).

Good advisors should pay for themselves. For example, if a strategic advisor wanted to charge you $25,000 to analyze your business and prepare a strategic plan, you might laugh. But, if taking the advisor’s recommendations resulted in $50,000 more in profit every year, then that was a good investment. Similarly, if you spend $10,000 preparing your business for sale, and garner a $30,000 higher selling price as a result, it was money well spent.

Randy D. Lewis’ Bio

Randy D. Lewis, CFA, CVA, MBA
LP Valuation, LLC
21051 Warner Center Lane, Suite 100, Woodland Hills, CA 91367
(818) 783-5006
rlewis@lpvals.com
www.lpvals.com

Randy Lewis, CFA, CVA, MBA, is a Managing Director in the business valuation and consulting firm, LP Valuation, LLC in Los Angeles, CA.

Mr. Lewis has extensive experience working with internet and tech companies, including SaaS and mobile app businesses, as well as professional service companies including health care practices, physicians, and attorneys. Other types of businesses include, but are not limited to, light manufacturing, beverage distributors, medical device distributors, retail and restaurants. The firm’s valuation clients have ranged in size from startups to corporations with sales in excess of $500 million.

Mr. Lewis has been a Certified Valuation Analyst since 2010 and a Chartered Financial Analyst since 1999. He has more than 20 years of experience in valuation and appraisal, and corporate finance, as well as business plan development, capital market consulting and strategic planning. He has prepared valuations for estate tax and planning, mergers and acquisitions, 409A and other financial reporting matters, and business and marital dissolutions.

Mr. Lewis has been involved in various litigation matters, primarily centered in business litigation, partnership dissolution, family law matters, as well as estate and gift tax matters. Some examples of litigation assignments Mr. Lewis has worked on include:

• Various valuation assignments in business acquisition, gifting, fractional partnership interests, marital dissolution
• Various projects assisting in settlements of marital dissolution
• Analysis of business fraud allegations and business valuation
• Computation of lost profits damages

He received his Bachelor’s Degree in Finance with honors from California State University, Fullerton, an MBA from the Anderson School of Management at UCLA, and earned the Chartered Financial Analyst (CFA) designation in 1999 and the Certified Valuation Analyst (CVA) designation in 2010. He is also an accounting and finance lecturer at the Martin V. Smith School of Business & Economics at California State University, Channel Islands (CSUCI), and an assistant professor of finance at Los Angeles Pierce College.

Mr. Lewis’ most recent article, “DLOM for Fractional Interests in Real Estate Partnerships: A Common Sense Approach,” was published in the May/June 2014 issue of The Value Examiner.