Title goes here 1. Valuing a Business: Why It Involves More than Applying a Multiple. Agenda. Valuation Services. March 2, 2017

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1 Valuing a Business: Why It Involves More than Applying a Multiple March 2, 2017 Paul Ouweneel, CFA, CPA, CFP Valuation, Litigation, Transaction Services 1 Agenda Introduction Paul Ouweneel, CFA, CPA, CFP, Vice President, Milwaukee Valuation Services Overview of Value Considerations What is Value? Value Attributes What increases/decreases value? Income vs. Risk Business Valuation Process and Methods Income, market, and cost approaches 2 Valuation Services Valuations are prepared for the following purposes: Purchase and Sale of Business Set value for purchase price Divorce Need to know for separation of assets Tax/Government Regulations Value for assessing tax on transaction Gifting and Estate Settlement If transfer ownership, need to record and understand value of gift or upon transfer at death Shareholder Disputes Value for buyout Financial Reporting Need value to record on GAAP statements Compensation Value of stock options or warrants or ESOP (Employee Stock Ownership Plans) Litigation/Contract Disputes e.g. Value of lost profits Planning Help shareholders understand value for transition planning 3 Title goes here 1

2 What is Value? It must be transferable There is nothing left to business if you leave; what is there for a buyer to buy? Future oriented It s all about the Future, not Past. The past is only a guide; what happens after the purchase is what matters. Can be hard to predict. Return in investment Must be able to get a return on investment. Sorry, but your sweat equity means nothing to a buyer. Supply versus demand If supply of business is high and demand for buying business is low, purchase price is affected. What is Value? Fair Market Value is defined as: The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Other definitions for value: Investment Value (used for purchase/sale for investment purposes or if you are buying a business that will create a job for you) Fair Value (used for financial reporting or shareholder disputes) Synergistic Value (Increased value if existing business will benefit from acquisition) Silly Value (My definition: Price paid that is just plain silly ) Title goes here 2

3 What is Value? Value is different for different people Finding the buyer that values the strengths and can do the most (i.e., make the most money) with the investment is key to maximizing value Note: May not be considered Fair Market Value Assume all relevant knowledge (Have you ever had buyer remorse?) What Attributes Can Affect Value? Risk vs. Return Value is driven primarily by Risk (Rate) vs. Return (Income) Risk Value Income Value 9 Title goes here 3

4 Value Attributes Which One would you Buy? 10 Value The basic (very basic) valuation formula is: INCOME (/) RATE = VALUE ($100k/20% = $500k) Or INCOME (X) Multiple = VALUE ($100X 5 = $500k) Income is Future (not Past) Rate and Multiple is based on Risk Characteristics Income needs to be consistent with Rate Used e.g. can t use pre-tax rate with after-tax income Notes: Need to consider what Assets are included in the Income utilized to arrive at value. May need to add Excess assets, subtract liabilities, etc. 11 Value Attributes Attributes Inside the Company: Customer base Management team Personnel Facilities Equipment Products and services Key contracts Management 12 Title goes here 4

5 Value Attributes Attributes Outside the Company: Competition Industry outlook/growth prospects Economic outlook Government regulatory climate 13 Risk vs. Return Impact of Risk on Rate of Return Risk Rate of Return Risk Rate of Return Note: Opposite is true for Market multiple (increase risk, decreased multiple. Decreased risk, increased multiple) 14 Attributes That Can Increase Risk High Debt Level High concentration of sales to one customer Reliance on Key Employee (1 salesperson drives all sales) Reliance on Key Manager (e.g. 1 employee managing business) Reliance on 1 supplier (distributor with 1 supplier) More intangible assets compared to tangible assets Current assets least risky (easily turned into cash) Fixed assets a little more risky (not as easily turned into cash) Intangible assets (trade name, customer base, goodwill, etc.) Lots of competitors Low barriers to entry (restaurant, consulting firm, retail store) 15 Title goes here 5

6 Earnings Considerations Trend in operations (sales, gross profit, operating income, net income, etc.) Are sales growing? Will they grow in future? Are expenses growing? Will expenses increase more than sales in future? Look for nonrecurring expenses Look for owner expenses that could be adjusted (replacement wages would be less, vehicle, business and entertainment, etc.) Are taxes calculated? (If S corp., taxes not included) Rate/multiple should be consistent with Income level! e.g. Don t apply a net income multiple to EBTIDA (earnings before taxes, interest, depreciation, and amortization) Don t apply an after-tax cap rate to pre-tax earnings 16 Appraisal Process Define the Engagement Gather Data Analyze the Data Arrive at a Valuation Conclusion Summarize Findings and Write the Report 17 Valuation Methods Combined Fair market Value of each asset owned by a company (A/R, inventory, fixed assets, intangible assets) Current assets + Fixed Assets + intangibles defined - Liabilities = Value of Equity Value based on present worth of future economic benefits Earnings Expected Rate of return = Enterprise Value Value based on market/sale data of similar (guideline) companies Earnings X Multiple = Enterprise Value 18 Title goes here 6

7 Levels of Value Methods need to consider Assets of company in all approaches 19 Valuation Methods Why we look at all 3 methods: Each method considers different important attributes If projected earnings are negative, income and market approach arrive at negative value. But would there still be market for inventory, accounts receivable, fixed assets? - Yes! Income and market approaches used to arrive at Goodwill value. If goodwill value comes in high, may need to ask whether value is reasonable. Can you start business from scratch? Is goodwill transferable? If goodwill value is high, risk is higher. Analyzing balance sheet through cost approach, helps you assess adjustments to earnings and excess assets to be added. 20 Cost Approach Always need to consider Assets/Liabilities included in a deal when Assessing Value!! (If you just apply a multiple, you are not considering what Assets are included in the deal) Most small business transactions are Asset Deals, but. Some include accounts receivable, and some don t Some include assuming liabilities, and some don t If accounts receivable are not purchased, should value be less? YES If assuming liabilities, should value be less? YES 21 Title goes here 7

8 Income Approach Projected earnings stream is discounted to present value using a discount rate, which reflects market conditions and risk. It is crucial that the rate chosen is consistent with the earnings stream utilized. For Sellers, normally need to subtract debt from a purchase price. Just like when you buy a house, a buyer doesn t normally assume debt. Sellers don t always think about the net proceeds (sale price less debt to be paid off after sale). 22 Income Approach 23 Income Approach 24 Title goes here 8

9 Market Approach Guideline Private Transactions or Guideline Publicly Traded Companies Use transactions from privately held companies and calculate the multiple they received for the sale of their business or Find publicly traded companies and calculate the multiple they are currently trading at as a multiple of earnings Should use Guidelines with similar industry/size to factor in similar risk characteristics May want to Exclude Silly Value Multiples 25 Market Approach: Example 26 Market Approach Multiples can be applied to revenue, Gross profit, EBITDA (Earnings before Interest Depreciation, and Amortization) or Book Value. Are multiples different depending on Industry? YES! See Risk Factor impacts. e.g. Construction company includes a large amount of fixed assets, so have lower risk than IT company with no fixed assets Are multiples different based on size? YES! Riskier if company is smaller and less diversified Are multiples different based on geography? Not necessarily, but demand may be higher in different regions which can affect multiples 27 Title goes here 9

10 Market Approach EXAMPLE OF RANGE OF MULTIPLES Professional services business: 3 to 5 times Normalized EBITDA Manufacturing business: 3 to 6 times Normalized EBITDA Real estate: Often 8 to 12 X Normalized EBITDA Why higher? Can finance real estate over 20 years or more. Real estate is fairly stable and has salvage/liquidation value. Normalizing EBITDA is the most important piece of the puzzle, yet often overlooked or misunderstood. Should be based on future expectations. In addition, some assets are not assumed to be included in the formula (e.g. nonoperating assets such as owner s plane, condo in Cayman Islands, etc. need to be added if anticipated to be bought.) 28 Summary Asset Base (current, fixed, intangible) Excess Assets Changes in future income Risk factors Future Debt structure Non-operating assets Difference in market multiples based on size Future potential industry growth Tax impact Nonrecurring expenses/income Assets included in deal Trends in earnings Ability to finance Current Debt structure Non-operating income and expense Market compensation Difference in market multiples by industry Obsolete assets Assets and liabilities being acquired/sold Other factors that affect value that could be different for your company.. 29 Paul Ouweneel, CFA, CPA, CFP Vice President with 10 years of experience consulting with high-net worth individuals and companies specializing in valuation as well as sell-side and buy-side merger and acquisition advisory. Specializes in the valuation of businesses and intangible assets as well as sale and purchase transaction support for companies in a variety of industries Designations: Chartered Financial Analyst Certified Public Accountant Certified Financial Planner Professional Master of Professional Accountancy with emphasis in Finance BBA Accounting, University of Wisconsin-Whitewater Past experience includes Robert W. Baird & Co., Inc. and Deloitte Investment Advisors LLC 30 Title goes here 10

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