Small Business Valuation Overview and Analysis

Transcription

1 Small Business Valuation Overview and Analysis presented by Tim Mezhlumov, EA, CFP, CLU

2 Business Valuation - Definition The process of determining the economic value or Fair Market Value (FMV) of a company Three Key Elements: 1. Process 2. Determination of factors affecting Valuation 3. Arrival at FMV

3 Fair Market Value (FMV) IRS Definition of Fair Market Value: The price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.

4 Transfer Methods Transfer Methods During lifetime Sale Company vs. Asset Sale Gift cost basis carryover At death Bequest personal property Devise real property Cost basis is stepped up except certain assets subject to Income in Respect of Decedent (IRD) assets including 401(k) plans, Pensions, IRAs, annuities and installment notes

5 Federal Transfer Taxes Sale - Capital Gain Tax Typically Form 1040, Schedule D Gift Tax Form 709 Estate Tax Form 706

6 Transfer Tax Value Transfer Value for tax purposes can be vastly different from FMV due to reasonable discounts including: Lack of control Minority interest Voting restrictions Non-voting interest Transfer restrictions

7 Valuation Methods Asset approach Income or EBITDA approach Market approach

8 Asset Approach Typically used with businesses with substantial tangible assets: Inventory Equipment Adjusted Book Value Assets, with adjustments (e.g. depreciation), less liabilities

9 Income Approach Uses prior earnings to estimate company value based on income potential Most appropriate for businesses with consistently strong earnings Methods Capitalization of Earnings Excess of Earnings Discounted Cash Flow Multiple of Discretionary Earnings

10 Income Approach Capitalization of Earnings Method Applicable for businesses with few or no tangible assets

11 Income Approach Excess of Earnings Method Generally for manufacturing-based firms with significant assets

12 Company Value and Taxes

13 Effect of TCJA

14 Inputs Inputs Current riskfree rate = 2.41% Risk Premium = 5.08% Pre-tax reform Post-tax reform Comments Beta Relative risk of all firms should not change Pre-tax cost of debt 3.91% 3.91% Assume that bond investors still demand same default spreads Marginal Tax Rate 38.00% 24.00% Drop in federal corporate tax rate to 21% + state & local taxes (3%) Debt to Capital Ratio 23.51% 23.51% Assume no change in the debt to capital ratio Revenues $12, $12, Base year revenues unchanged Operating Income (EBIT) $1, $1, Base year pre-tax operating income unchanged Effective tax rate 25.19% 20.00% Lower effective tax on operating income. After-tax return on capital 12.76% 13.65% Increase to reflect lower effective tax rates Reinvestment Rate = 59.27% 65.00% Increased reinvestment from new capital expensing rules Length of growth period = 5 5 Has to converge on overall economic growth sooner rather than later Computed Values Pre-tax reform Post-tax reform Cost of Equity = 7.85% 7.85% T.Bond rate = 2.41%; ERP = 5.08% After-tax cost of debt = 2.42% 2.97% Use marginal tax rate Cost of capital = 6.57% 6.70% After-tax return on capital = 12.76% 13.65% Use effective tax rate Reinvestment Rate = 59.27% 65.00% Expected growth rate= 7.56% 8.87% Return on capital * Reinvestment Rate Value of firm PV of FCFF in high growth = $2, $2, Terminal value = $30, $34, Value of firm today = $24, $27, Effect on Value Value with existing tax code $24, Value with new tax code $27, Change in value $2, Percentage change in value 9.70%

15 TCJA Major Changes Reduction in corporate tax rate Sec 199A Qualified Business Income (QBI) Deduction

16 Effects of TCJA TCJA places certain limitations on the deductibility of interest expense Companies with higher debt levels may see a further increase in the cost of debt, making equity financing increasingly more attractive

17 Effects of TCJA Reduced deduction for corporate dividends that C corporations receive from other corporations Repeal of the 20% corporate alternative minimum tax (AMT) New limit on interest expense deductions for businesses with more than $25 million in annual revenue

18 Effects of TCJA More generous business asset expensing and depreciation tax breaks (though the expanded bonus depreciation breaks are only temporary) Elimination of the Section 199 deduction (commonly referred to as the domestic production activities deduction or manufacturers' deduction) Limited deductions for "excess business losses" incurred by non-corporate taxpayers

19 Effects of TCJA Liberalized eligibility rules for the cash method of accounting Elimination of like-kind exchanges for personal property assets Limitations on compensation deductions for amounts paid to principal executive officers In addition, after 2022, certain R&D expenses must be capitalized and amortized over five years, or 15 years if the R&D is conducted outside the United States instead of being deducted currently.

20 Effects of TCJA Limitation of business interest to 30% of adjusted taxable income Bonus depreciation of 100% of qualified property until 2022 and then a step down in percentages from 80% to 0% between 2023 and 2027 The varying effect of 20% QBI deduction for S corporations depending on whether they are service or non-service businesses

21 Effect of TCJA For the most part, the Tax Act will have an upward impact on Company Value Companies that have historically incurred high effective tax rates and/or invested heavily in capital expenditures will pay less in taxes, thus likely contributing to an increase in business value

22 Negative Effect of TCJA Companies that have historically incurred low effective tax rates, operating at a tax loss, investing little in capital expenditures and are heavily leveraged, will be negatively impacted thus potentially contributing to a decline in value

23 Most Important Valuation Factors* Cost of Capital Discounts *October 29, 2014 IRS white paper Valuation of Non-Controlling Interests in Entities Electing to be Treated as S Corporations For Federal Tax Purposes, A Job Aid for IRS Valuation Analysts

24 Discounts from FMV Economic vs. Tax Value Reasonable discounts reduce the Economic Value of Company for Transfer Tax purposes Tax Value (after discounts) is reflected on: Form 709 Federal Gift Tax Return Form 706 Federal Estate Tax Return

25 Ways to Increase Valuation Assure (financial) stability Key Person Life Insurance Buy/Sell Agreements for Owners Death Disability Other available agreement clauses loss of professional license, incarceration, admittance to rehab, personal conduct

26 Key Person Insurance

27 Key Person Insurance Tax Effects Premiums are not deductible to Company Death benefits are generally tax-free The increase in cash value of life insurance contracts is generally not taxed Policy surrender may result in taxable gain to Company if cash value exceeds premiums paid If policy is transferred to Key Employee: Company gets a deduction equal to Cash Value Employee owes ordinary FIT on Cash Value

28 Buy/Sell Agreement A legal document Ensures remaining Owners will purchase the exiting owner s interest from his or her estate Agreement requires Heirs to sell their interest Typically funded with life insurance due to lack of cash on hand Types of Agreements Cross-purchase, Entity Purchase, General Partnership Strategy

29 Cross-purchase Buy/Sell

30 Cross Purchase Buy/Sell Tax Effects Life insurance policy is individually owned Premiums are not deductible Death benefits are generally tax-free Cash value is included in estate If Company pays premiums, Employee is taxed Added to W2 Increase in Survivor s cost basis in Company Key benefit of Cross Purchase vs. Entity buy/sell

31 Entity Purchase Buy/Sell

32 Entity Buy/Sell Tax Effects Premiums are not deductible Death benefits are generally tax-free Sec. 101(j) notice and consent requirements If Company pays premiums, Employee is taxed Added to W2 No increase in Survivor s cost basis in Company because Company redeems shares of Deceased (vs. being purchased by survivors)

33 Tim Mezhlumov

34 Your company profile Entity type: S Corporation Industry: Service Industry State: IA Years in business: 12 Number of business owners: 2 Number of employees: Family business: No Financial statement summary This summary of your provided financial information was used to calculate the business valuations that follow. Income Revenues $12,490,000 $12,000,000 $14,090,000 Pre-tax operating income $599,000 $650,000 $740,000 Depreciation $110,000 $110,000 $110,000 Owner compensation $250,000 $264,000 $280,000

35 Your informal business valuation We ve provided values using five generally accepted methods of valuation. Your company profile suggests the highlighted value below may be most appropriate for your business. Adjusted book value method Assets, with adjustments, less liabilities - generally represents the "liquidation" value $1,000,000 Capitalization of earnings method Amount of capital that would have to be invested at a specified rate to yield the current average net annual earnings of the business Excess of earnings method A combination of the adjusted book value and capitalization of earnings methods Discounted future cash flow method Projected future business earnings forecast, then discounted using an appropriate rate Multiple of discretionary earnings method Earnings provided by goodwill, times a multiplier; adjusted book value is added to this number $2,638,000 $3,485,000 $2,503,000 $3,584,000

36 Calculations Assumptions... Average operating income: $686,000 Excess owner compensation 1 : $0 Capitalization rate: 26.0% Rate of return on assets: 4.0% Earnings multiplier: 4 Number of years to forecast: 4 Discount rate: 15.0% Growth rate: 8.0% Adjusted book value method Book value $1,000,000 Plus adjustments + $0 Adjusted book value $1,000,000 Capitalization of earnings method Average operating income $686,000 Plus excess owner compensation + $0 Total $686,000 Divided by capitalization rate 26.0% Capitalization of earnings $2,638,461 Excess of earnings method Average operating income $686,000 Plus excess owner compensation + $0 Less adjusted book value - $40,000 multiplied by rate of return on assets Total $646,000 Divided by capitalization rate 26.0% Excess of earnings on assets $2,484,615 Plus adjusted book value + $1,000,000 Excess of earnings $3,484,615 Discounted future cash-flow method Average operating income $686,000 Plus excess owner compensation + $0 Total $686,000 Growth rate 8.0% Number of years to forecast 4 Discount rate 15.0% Discounted future cash flow $2,503,000 Multiple of discretionary earnings method Average operating income $686,000 Plus excess owner compensation + $0 Less adjusted book value - $40,000 multiplied by rate of return on assets Total $646,000 Multiplied by earnings multiplier x 4 Total good will $2,584,000 Plus adjusted book value + $1,000,000 Multiple of discretionary earnings $3,584,000 1 Excess owner compensation is defined as salary over and above what the owner would pay a key employee to perform similar services that the owner is now performing, without incurring the additional risk of business ownership.