News & Articles

Team Member Spotlight: Dennis Echelbarger, CPA/CFF/CGMA

Posted on Mon, Apr 26, 2021
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Tags: Forensic Accounting, Valuation, Business Valuation, EHTC, Team Member

The Market Approach: A Touchstone in Valuation

Posted on Mon, Apr 19, 2021

The market approach, whereby appraisers use comparable "guideline companies" to help them estimate the value of a private business, has become a long-standing valuation touchstone.

Two primary valuation methods are categorized under the market approach:

1. Guideline public company method. Here, appraisers identify companies with stock (or partnership interests) that are actively traded in the public markets, such as the AMEX or NYSE. Then they calculate key financial variables, using the stock price and a variety of pricing multiples such as price-to-revenue, price-to-net income and price-to-book.

Financial variables may be calculated for a variety of time periods, such as next year's forecasted performance, the preceding 12 months, or an average of the last five years. The appropriate pricing multiple depends on case specifics and is a matter of the appraiser's professional judgment.

The subject company's fair market value equals the pricing multiple times the subject company's financial variable (for example, revenues, net income or book value). Because the guideline public company method is based on individual stock prices, under certain circumstances it generates a minority, marketable basis of value.

2. Merger and acquisition (M&A) method. For guideline transactions under this method, appraisers analyze sales of entire public or private businesses. So this technique typically generates a controlling, marketable basis of value.

Because private businesses aren't required to disclose sales to the SEC, finding out their details can be difficult. Fortunately, appraisers have access to several proprietary databases (such as DealStats, Done Deals and BIZCOMPS) that they can use to identify and analyze private deals.

Once appraisers have identified a relevant sample of potential guideline transactions, they calculate pricing multiples relative to key financial variables. Fair market value is a function of the pricing multiple and the subject company's financial metric (say, last year's revenues or book value).

Deciding Which Way to Go

The availability of transaction data is a key determinant of whether an appraiser uses the market approach. Pure players (companies that focus on a single target market or offer a limited menu of products) may be hard to come by in the public markets -- especially in industries dominated by conglomerates. And some industries lack a meaningful sample of M&A transactions, particularly those involving small niche participants.

In general, the guideline public company method makes more sense if the subject company is large enough to consider going public and when valuing a minority interest in a going concern business. Using this method to value a controlling interest may require subjective adjustments for control.

Conversely, the M&A method is generally more appropriate when valuing controlling interests. But, with proper adjustments and analyses, it can be used to value minority interests.

Other disadvantages of the M&A method are:

  • Transaction databases provide limited information about guideline companies.

  • Details provided are unverified.

  • The sales price may include buyer-specific synergies and undisclosed terms (such as installment sales, employment contracts and noncompete agreements).

Avoiding Mistakes

One common valuation mistake that may occur under the market approach is failing to adjust the financial statements of the subject company or the guideline companies to ensure accurate comparisons.

For example, nonrecurring items and discontinued operations may need to be eliminated. Or, for comparative purposes, appraisers may need to rectify accounting inconsistencies, say, for depreciation or inventory methods. Ideally, appraisers make these adjustments before selecting guideline companies and computing pricing multiples.

Inconsistent terminology may also lead to problems. Slight differences in the ways databases or appraisers define terms such as "cash flow" or "earnings" can trigger significant valuation differences. It's imperative to understand how each database defines variables as well as what's included (or excluded) in the selling price.

An Accurate and Defensible Valuation

The market approach has intuitive appeal: The value of an investment should be comparable to similar investments in the marketplace. But finding a reliable sample of comparable transactions isn't as easy as it appears, especially for small niche players. An experienced valuation pro knows the tricks to applying the market approach to derive accurate and defensible valuations. EHTC has a team dedicated to provide the appropriate valuation method to you.

About EHTC

EHTC is a dedicated, full-service CPA firm in West Michigan that focuses on helping clients to achieve their full potential through comprehensive accounting, finance and tax services. We are a local firm with large firm resources, using a team approach to proactive client service that helps our clients gain a competitive advantage through our ability to develop strategies and present realistic solutions that build value.

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Tags: Valuation, Mergers and Acquisition (M&A)

Goodwill: Personal or Business -- and Why Does It Matter?

Posted on Thu, Apr 08, 2021

You can't touch goodwill, but it's one of the most valuable assets for many businesses. Commonly associated with professional service firms, goodwill can also exist among manufacturers, retailers, contractors and other types of businesses. Valuing intangible assets, including goodwill, requires the use of a business valuation professional to get it done right.

Getting a Handle on Goodwill

The International Glossary of Business Valuation Terms defines goodwill as:

That intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.

Goodwill (or "blue sky" as it's also known) is often thought of as the difference between a business's fair market value and the value of its net identifiable tangible and intangible assets. Business owners and attorneys may need to gauge the value of goodwill -- and its underlying components -- in mergers and acquisitions, divorce cases, shareholder disputes, and various tax scenarios.

Different Types of Goodwill

If you talk with business owners or professional practitioners, many will tell you that their companies could not survive without them. That may be a bit of an exaggeration, but they do have a point. Traditionally, goodwill has been broken down into two components:

Business (or entity) goodwill. This belongs strictly to the entity itself. Business goodwill may arise from many sources, including the company's name, phone number, location, and special attributes, such as special menu items or recipes at a restaurant.

Personal (or professional) goodwill. This type of goodwill is directly attributable to an individual's characteristics or attributes. It includes not only the owner's skills, knowledge and reputation but also his or her contacts and relationships.

Personal goodwill can be further bifurcated into pure personal goodwill and transferable goodwill. Pure personal goodwill cannot be transferred to the entity or anyone else under any circumstance. These are often true personal relationships:

  • "We want John to testify in this case because we know what type of a witness he is. No one else will do."
  • "Wayne has developed the cultural relationship and ties necessary to gain the trust of a particular customer. Therefore, only Wayne is able to buy and sell the product to him."

If a business is sold, the buyer won't pay for pure personal goodwill, because it's something that will literally walk out the door with the seller.

Transferable goodwill is goodwill that is personal in nature, but might be transferred to the entity or to another individual with proper planning and adequate time. These could be personal relationships or specialized knowledge that could be transferred through training or development of other people. It could also include contact lists that have been developed over a period of time or customer (or vendor) relationships that can be transferred given effort and time.

Splitting Up Goodwill

So, how personal is your goodwill? Dividing goodwill among its three components -- business, pure personal and transferable personal goodwill -- requires professional judgment and careful consideration of the facts at hand. Valuators may perform different analyses to divvy up goodwill that include:

Evaluate comparable transactions. Search for similar business sales in proprietary transaction databases. Theoretically, these deals should not include any pure personal goodwill, because no rational buyer would pay for an asset that walks out the door with the seller. But beware, a comparable business could rely more (or less) on pure personal goodwill than the subject company.

For example, an accounting firm in an urban market with 10 partners and 100 employees would be more likely to possess business or transferable personal goodwill than a three-partner firm that operates in a small, rural market and employs just a receptionist and one bookkeeper. Clients of the smaller firm may be attracted solely to an individual practitioner and his or her reputation. Clients of a mid-sized urban firm might be attracted to the firm's location, name recognition and diversified staff of professionals, however.

Consider conditions of sale. Some databases also list the details of employment, consulting or noncompete agreements between the buyer and seller as a condition of sale. The value similar businesses assign to these agreements can be used as a basis to estimate transferable personal goodwill. But, beware, these agreements might be based on gut instinct or driven by tax strategies, rather than market value.

Estimate the cost of an orderly transition. Some personal goodwill can be transferred to new owners through an orderly transition. The selling owner can remain for some period of time with the business to maintain a presence, introduce the new owner, and facilitate a rapport-building program with the employees, customers, and suppliers. The estimated costs of the selling owner's compensation plus other direct expenses during the transition can be used as an estimated value of personal goodwill.

Even in an orderly transition, some customers may be lost, so it's also important to consider the expected loss of revenue. Some customers simply can't be transitioned over to the new owner, no matter how hard the buyer and seller try. Beware however, that some customer loss may be due to operational changes made by the new owner, so it can be argued that the revenue lost from these changes is not related to personal goodwill.

Bottom Line

Knowing how to differentiate and value the components of goodwill is important if you're buying or selling a business -- or if you face litigation that involves the value of a business interest, such as a marital dissolution or shareholder dispute. Splitting goodwill may seem like splitting hairs, but it should be done in logical way by a valuation expert who understands all of the interconnections and implications.

About EHTC

EHTC is a dedicated, full-service CPA firm in West Michigan that focuses on helping clients to achieve their full potential through comprehensive accounting, finance and tax services. We are a local firm with large firm resources, using a team approach to proactive client service that helps our clients gain a competitive advantage through our ability to develop strategies and present realistic solutions that build value.

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Tags: Valuation, Business Valuation, Goodwill

How Elements of Control Affect Value

Posted on Mon, Nov 30, 2020

We've all heard the phrase that the "whole is greater than the sum of its parts." But you might not know that the same theory can apply in the valuation of interests in a business.

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Tags: Valuation, Shareholder

Team Member Spotlight: Mike Kamp, CPA/CVA

Posted on Mon, Nov 09, 2020
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Tags: Tax Planning, Certified Valuation Analyst (CVA), Valuation, Business Valuation, Team Member

Business Valuations Are Not Commodities

Posted on Thu, Nov 05, 2020

Privately-held business owners might need appraisals of their interests for many reasons, including:

    • Strategic planning,
    • Mergers, acquisitions and shareholder buy-ins (or buy-outs),
    • Equitable distributions of marital estates,
    • Minority shareholder disputes,
    • Bankruptcy,
    • Small business loans, and
    • Gifts and estate planning.

Some owners may be tempted to seek the offering with the lowest price tag. After all, a business valuation is just a formality, isn't it? Many owners perceive formal appraisals as something required by an outside party -- such as the IRS, a judge or a lender — in order to obtain approval or comply with a regulatory requirement. But a valuation actually provides insight into a company's current market value, as well as key value drivers to enhance value going forward. A valuation can also serve as a wake-up call for business owners with unrealistic expectations.

Is a Calculation a Viable Alternative?

To save time and money, many clients ask for calculation letters instead of full written appraisal reports. Calculations are usually only one or two pages long, and they're only appropriate in limited circumstances.

Calculations may be appropriate, for example, when using a valuation solely for internal purposes or when deciding whether it's financially feasible to pursue litigation. Most appraisers wouldn't recommend a calculation for tax or litigation purposes, however.

By comparison, full written appraisals generally average about 50 pages in length. This level of detail enables outsiders to understand the analyses and replicate the arithmetic underlying a valuator's conclusion.

Sometimes calculations limit the scope of the work an appraiser performs. If so, a valuator's conclusion could change materially if a calculation engagement evolves into a full scope appraisal.

Varying Degrees of Expertise

Many people provide business valuation services, but their qualifications vary significantly. At one end of the spectrum is a valuation professional who has achieved the training, experience and continuing education requirements of one of the following business valuation organizations:

  • The American Institute of Certified Public Accountants (AICPA),
  • The American Society of Appraisers (ASA),
  • The Canadian Institute of Chartered Business Valuators (CICVA), and
  • The National Association of Certified Valuation Analysts (NACVA).

On the other end of the spectrum are online business valuation calculators and fill-in-the-blank software, which are typically based on oversimplified formulas or industry rules of thumb. Computerized models aren't a substitute for an appraiser's professional judgment and training. In short, you get what you pay for.

Appraisals Guide Major Decisions

In the words of NASA astronaut Alan Sheppard, "I wasn't scared, but I was up there looking around, and suddenly I realized I was sitting on top of a rocket built by the lowest bidder." Sheppard got lucky and returned from the moon to tell his tale. But are you willing to bank on the work of an amateur appraiser or computer model? An inexpensive provider may actually cost more over the long-run by skipping steps, overlooking unrecorded asset and liabilities, and failing to support conclusions with real-world evidence.

For most entrepreneurs, their business interests are their most valuable asset. Many important decisions — such as selling the business, obtaining a loan or splitting up a martial asset — hinge on business appraisals. If your appraisal is inaccurate, you could lose money or be sued or audited by stakeholders.

For example, if the IRS challenges a valuation prepared for gift and estate taxes, you're more likely to withstand scrutiny with a qualified appraiser. The IRS defines a qualified appraiser as:

An individual who has earned an appraisal designation from a professional appraiser organization, or has met minimum education and experience requirements in the subject matter in which he or she issues appraisals. A qualified appraiser performs appraisals on a regular basis, and receives compensation for his or her work. The professional must not be prohibited from practicing before the IRS.

Obviously, a qualified appraiser isn't someone who bases his or her conclusion on limited information submitted over the internet. It's someone who's dedicated significant time and attention to mastering the business valuation discipline.

Know What You're Buying

You might be thinking, "No one outside the company will ever see this appraisal. Why do I need to use a qualified appraiser?" While valuations prepared for litigation or tax purposes run the risk of outside scrutiny, reliable valuation conclusions are equally important for internal planning purposes. Inaccurate valuations can lead to poor investment decisions.

But hiring a valuator isn't as familiar and straightforward as buying, say, a car. How do you know whether a valuation "professional" is a shiny new Cadillac or a stripped-down jalopy? When evaluating business valuation candidates, price is one indicator of quality, but professional credentials are far more relevant. Investigate the business valuation organizations to which prospective valuators belong. Each organization has its own training, experience, ethics and standards, and continuing education requirements.

Also inquire about your valuator's standard operating procedures, data requests and expected timeline. Comprehensive valuations take weeks (or months) to complete. It takes time to learn how the company operates, conduct site visits, interview management, analyze the data and write a full report.

Likewise, take your time when selecting a valuation expert. Never jump at the first valuation provider you encounter online. Discuss the decision with your trusted financial and legal advisors first.

About EHTC

EHTC is a dedicated, full-service CPA firm in West Michigan that focuses on helping clients to achieve their full potential through comprehensive accounting, finance and tax services. We are a local firm with large firm resources, using a team approach to proactive client service that helps our clients gain a competitive advantage through our ability to develop strategies and present realistic solutions that build value.

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Tags: Valuation, Business Valuation

Who Will Run Your Business After You?

Posted on Mon, Jul 13, 2020

If you're a business owner, do you have a plan in place that names who'll follow you as head of your company? You may feel you're too busy running the business today to waste time on long-term plans that seem so distant. But there may be more reasons than you think to make decisions, some of which will benefit you today. A well-thought-out plan will:

  • Allow you to shape the fate of your business,

  • Preserve the value of your business during a transition,

  • Reduce income and estate taxes, and

  • Minimize the risk of intrafamily discord, when children play a role in your business.

Whatever you decide to include in your business succession plan doesn't need to be cast in stone. But just like a last will and testament, while you can, you need to make your future wishes known, and still allow for changes during your lifetime. Depending on the particulars, you can modify your plan as circumstances change. The trick is to be careful not to make promises you might not be able to keep.

Also similar to creating a will, you don't have to reveal the full contents of your business plan to all impacted parties immediately, though some plans should be made apparent early on. That's especially true if you decide you'd like to pass your business to heirs and need to start preparing them for that contingency.

Are you wondering about the value of your business and how much it is worth? EHTC is here to help with our Transaction Advisory Services team. Email Erik Olson at eriko@ehtc.com or call the EHTC office at (616) 575-3482 for any business valuation needs, especially in West Michigan.

Define Your Bottom Line

Perhaps the most fundamental question that a succession plan needs to address is: how much value will you need to take out of the company to meet your retirement and estate planning needs? The answer will influence whether you'll need to sell the company or transition some or all of the ownership to your heirs, assuming you have heirs willing and able to do so. If transitioning ownership is the plan, you can employ technical experts to use tax-efficient strategies, such as gifting, to achieve that goal.  

If you lack suitable heirs, an alternative to selling the company to an outside buyer is trying to facilitate the purchase of the business by your key employees. That can't be accomplished overnight and typically involves "nonqualified" (limited tax breaks) executive compensation plans, loans and possibly a "key man" life insurance policy.

Suppose you aren't trying to pass the business on to your heirs and you want to pursue employee ownership of your company. A leveraged employee stock option plan (ESOP) could be a viable succession planning/ownership transition mechanism.

The ESOP trust borrows funds to purchase company stock from the business owner. Then units of stock are periodically awarded to eligible employees and, over time, vested. When those employees retire, their shares are repurchased by the ESOP, allowing those employees to benefit from any increase in the company's value. Meanwhile, the company makes tax-deductible ongoing cash contributions to the ESOP trust to cover the loan it took out to buy the owner's shares.

Secure Senior Management

Even if you expect to sell the company to an outside buyer, you could enhance and preserve its value if you downsize your role and transition management responsibility to your senior executives, including an heir-apparent CEO. Assuming the new team is successful, an outside buyer wouldn't consider your departure as big a risk to the ongoing success of the company or worry about the need to make immediate changes to protect the investment.

Unless you plan to sell or hand off your business to children soon, it's crucial to avoid planning solely by looking at the company as it's structured today. Think instead about how various functions will be performed before your departure.

Suppose, for example, you're thinking about stepping out of the picture in 10 years, and your business evolves along the lines you're hoping it will until then. Would your organizational chart look the same then as it does now? What new roles and areas of expertise will be required a decade hence to run the business successfully?

If your business today is too small to accommodate your adult children on the payroll in key positions, perhaps it will then. Keep that in mind as you start to build your succession plan. At the same time, give children enough of an opportunity to receive proper training and demonstrate their capabilities and passions. If they aren't up to the job, all stakeholders suffer, including your children.

Similarly, don't limit your planning to focus exclusively on a future CEO. Think about the next management tier, and who'll be filling those slots, and how they can develop the skills and experience to fill them well. Those decisions will be informed not only by looking at your company's present needs, but the challenges you expect it to face in the future.

A Place for the Kids?

Whether you expect leadership roles and ownership stakes to be assumed by your heirs or by key employees, those stakeholders need to play a role in the succession planning process. It's particularly critical in the case of children who may not have had much involvement with the company. In that situation, you can't make assumptions about their desires, nor their capabilities, when folding them into a succession plan.

In a privately held company, it's only natural for nonfamily member employees to wonder what will happen to their jobs when the principal owner retires. As noted, while you shouldn't make promises that you may not be able to deliver on, key players will be reassured about their future if they believe you value them and expect them to remain on board after you leave the scene.

Today is Tomorrow for Your Business

Your succession plan should be a general roadmap for the future of your business without you, as well as to help inform your decisions about the business today. While it will likely require some precise legal arrangements (such as trusts, employment contracts, life insurance policies and executive compensation plans), don't let the tail wag the dog. As noted, your succession plan can evolve as circumstances dictate. Having a plan is the goal, but don't paint yourself into a corner.
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Tags: Succession Planning, Business Succession, Valuation, Business Owner

Myths and Truths about Business Valuation

Posted on Thu, May 16, 2019

The business valuation profession has grown rapidly since 1980. Over the decades, it has developed from a rudimentary process into a highly sophisticated mix of art and science to determine the value of a business or business interest. However, many business owners and investors fail to understand the valuation process and its results. Here are some common business valuation myths and the underlying truths.

Myth: You appraised the "fair market value" of my business. When I sell my business interest, this is the price I will receive.

Truth: Fair market value (FMV) is different from a transactional (or strategic) value. FMV is hypothetical. If you look at the definition, FMV requires consideration of the universe of hypothetical buyers and sellers. The resulting value determination can be looked at as a "most likely" value given the hypothetical considerations. A transaction value, on the other hand, is a verifiable amount, a price at which the business actually changes hands and not an estimate of value that is the result of FMV. Transactional value may be significantly higher (or lower) than fair market value, depending on the circumstances.

Myth: As a business owner, I have the best idea of what my business is worth.

Truth: While the business owner might know the most about their business, that knowledge alone isn't enough to qualify the owner to value the business. Valuation has developed into a profession with accreditations, standards, and professionals with experience and knowledge in how to determine the value of a business. The valuation professional also is an objective third-party. Business owners tend to view their businesses differently than outsiders -- often through "rose-colored" glasses. Owners need to understand how outsiders view the business -- because it's hypothetical investors that determine FMV.

Myth: If a business is worth $1 million, my 10 percent interest should be worth $100,000.

Truth: Owning a minority (or less than controlling) interest in a business diminishes the interest's value from the pro rata value of the entire business. A minority interest cannot determine policy, set compensation for officers and other owners, or decide when and whether to sell the business or significant assets of a business. There are many other items that cannot be controlled by a minority owner. The diminished value can be materially less than the pro rata value, depending on the facts and circumstances.

Myth: The owner's contributions to a business enhance the value of the business.

Truth: An owner's contributions often enhance the value of a business, but there's a major exception. Owners may possess talents, relationships or other intangible assets -- often referred to as "personal goodwill" -- that cannot be transferred to buyers. Owners who contribute personal goodwill diminish the value of the business to an unrelated party. For example, if the owner has contacts with long-term customers that are not likely to transfer to a new owner, the business will likely lose those customers when the current owner leaves the business. That, of course, will reduce the value of the business.

Myth: Value is value, so I can use a valuation report for multiple purposes. For example, I could use a report that is prepared for estate planning purposes to get a loan, settle a divorce or support value on a gift tax return.

Truth: A business valuation is prepared for a specific business as of a specific date and for a specific purpose. If any of those parameters change, the valuation is no longer valid. Different purposes for a valuation might require a different standard or basis of value. For example, the valuation of a minority interest for gifting purposes cannot be used to determine the asking price of the business when the owner wants to sell the entire business two years later. It's important that the user of a valuation report understand its use limitations.

To attain a better understanding of business valuation, owners and investors should discuss the valuation process and various options with an EHTC appraisal professional. Please contact Erik Olson at ErikO@ehtc.com or by calling (616) 575-3482.

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Tags: Valuation, Business Valuation, Business Owner

A Closer Look at the Excess Earnings Method

Posted on Tue, Jul 17, 2018

The Excess Earnings Method was originally created to compensate wineries and distilleries during Prohibition. Valuation experts often criticize this method, calling it ambiguous, over-simplified or outdated. But it's still used in some jurisdictions as a way to value small businesses and professional practices, especially in a divorce setting.

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Tags: Valuation, Business Valuation, Small Business

Lack of Marketability Discount Requires Empirical Support

Posted on Wed, Mar 08, 2017

The discount for lack of marketability is an often-contested valuation adjustment that requires a particularly detailed process. When calculating any valuation adjustment, an appraiser obviously can't just pick a number out of a hat.

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Tags: Appraisals, Valuation, Business Valuation