--Working ON your Business, not just IN your Business-- Understanding and Increasing Business Value American Cheese Society July 30, 2016
TODAY S AGENDA What really matters in business valuation? Is your business transferable? Why every business has more than one value. Can t I just use an industry rule of thumb? Why a company s financial statements do not indicate the value of the business. How is a business valued? How can value be increased?
But I m Not Ready to Sell Investment vs. Employment Identifying your successor is a fundamental objective Value can be increased if you have time and understand the drivers In Madison: (608) 257-2757
Is the business actually a transferable entity, or is it a career with the tools of the trade?
The Transferable Business Has Two Key Characteristics* The business is not dependent on a specific individual with skills or relationships that cannot be transferred. The business generates sufficient cash flow for BOTH market compensation and return on investment.
Is it Transferable? Year 1 Year 15 vs.
What about Those handy rules of thumb? Multiple of Revenue? Multiple of EBIT? Multiple of EBITDA?
ABC Cheese v. XYZ Cheese 4.35 x EBITDA ABC Company High employee turnover 26% of revenues from one customer No contracts for future work Facilities at capacity Contracts do not allow for surcharges New competitor just came to town XYZ Company Low-no employee turnover 4% of revenues from one customer Contracts in place for future work Facilities at 60% of capacity Contracts do allow for surcharges Competitive landscape unchanged
Fair Market Value The cash or cash-equivalent price at which the security would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts. Article 20.2031-1(b) of the Estate Tax Regulations and Revenue Ruling 59-60, 1959-1 C.B. 237
Prospect Ranking Chart Buyers of a Business Enterprise Highest Enterprise Value 9 Strategically Positioned Businesses 8 Diversifying Businesses 7 Competing Businesses 6 ESOPs 5 Outside Investors/Managers 4 Insider Management Group 3 Diversified Passive Investors 2 Investor/Job Seeker 1 Undiversified Passive Investors Lowest Enterprise Value
Business Valuation Approaches Asset Approach Income Approach Market Approach
Asset Approach Determines value based on the current market value of underlying assets Seldom used for operating companies Relied upon for real estate or investment holding companies May not be applicable if business is a going concern or minority interest is being valued
Asset Approach to Value Asset Approach to Value Balance Sheet Adjustment To Restated As Reported Market Value Balance Sheet Cash $ 50,000 $ 50,000 Accounts Receivable 200,000 (25,000) 175,000 Inventory 450,000 (50,000) 400,000 Plant & Equipment 750,000 1,000,000 1,750,000 Land 250,000 1,000,000 1,250,000 TOTAL ASSETS 1,700,000 1,925,000 3,625,000 Accounts Payable 100,000 100,000 Interest-Bearing Debt 500,000 500,000 Built-In Capital Gain Tax 350,000 350,000 TOTAL LIABILITIES 600,000 950,000 NET EQUITY $ 1,100,000 $ 1,575,000 $ 2,675,000 - -
Market Approach Are there any comparable transactions whose data we could apply to our subject company? Guideline public companies Comparable private transactions Prior transactions in the subject company
Income Approach Value today is the present value of future economic benefits
Two methods Income Approach Capitalization of earnings only if future will look like most recent year(s) Discounted future cash flows most detailed method for reflecting the specific company s expected future
Income Approach Capitalization of Earnings Involves a numerator A single number intended to represent the future economic benefit Involves a denominator Represents the rate of return required by the investor
What s the Problem? Based solely on the income statement Past performance No allowance for future capital expenditures No allowance for future working capital needs Cash Accounts Receivable Inventory Capital Structure: relies on cost of equity only
GAAP Accounting Was Never Intended to Reflect Value GAAP accounting captures utilization of assets and capital at work Value is based on capacity, not utilization Accounting is backward looking Value is forward looking
Analyzing the Business Enterprise
What s Different? The DCF Method reflects the future business plan for the business: Models the business s future expected performance More detailed cash flows Allows for varying capital expenditures Allows for varying working capital needs Allows for cost of capital that includes debt and equity (weighted average cost of capital)
Discounted Cash Flow Projections Projections Normalized Year 1 Year 2 Year 3 Base Revenues $7,600,000 $8,512,000 $9,873,920 $9,478,963 12% 16% -4% Cost of Goods Sold 6,080,000 6,809,600 7,899,136 7,583,171 Gross Profit 1,520,000 1,702,400 1,974,784 1,895,793 Operating Expenses Payroll 760,000 775,200 790,704 866,518 Payroll Taxes 68,400 69,768 71,163 78,587 Rent 38,000 38,760 39,535 40,326 Utilities 12,000 12,240 12,485 12,734 Telephone 12,000 12,240 12,485 12,734 Professional Fees 34,000 34,680 35,374 36,081 Interest Expense 46,000 43,384 39,743 35,915 Depreciation 24,000 26,143 30,429 34,714 Total Operating Expenses 994,400 1,012,415 1,031,917 1,117,610 Net Operating Income $525,600 $689,985 $942,867 $778,183 EBITDA 595,600 759,512 1,013,038 848,812
Developing Equity Capitalization Rate Risk Free Rate 4.00 Equity Risk Premium 5.00 Industry Risk Premium 4.20 Size Premium 9.00 Specific Company Risk 4.00 Total Expected Return 26.20 Less long-term growth (3.00) Capitalization Rate 23.20
The Conclusion: Discounted Cash Flow Projections Projections Year 1 Year 2 Year 3 Calculation of Cash Flow EBIT 733,369 982,610 814,098 Plus Depreciation 26,143 30,429 34,714 Change in Working Capital (58,200) (86,912) 25,204 Cash Flow from Operations 701,312 926,126 874,016 Capital Expenditures (46,000) (30,000) (30,000) Cash Flow to Investors 655,312 896,126 844,016 Distribution for Taxes (263,296) (375,275) (302,351) Advantage of S Election 79,111 144,281 169,841 Cash Flow to Investors after Taxes 471,127 665,132 711,506 Weighted Average Cost of Capital 21.30% PV of 10 Years CF to Debt & Equity Investors 3,084,441 PV of Perpetuity 1,048,345 Total PV of Invested Capital 4,132,786 Less Interest Bearing Debt (900,000) 100% Equity Value $3,232,786
So Why Doesn t.. Value = Price???
Bargaining Position: The Fulcrum of Price* Value does not equal price What is the motivation of the buyer? What is the motivation of the seller?
How Can A Business Owner Increase Value?
Think Like a Buyer.. Economic Risk general economy and industry it s about timing Financial Risk it s about consistency volatility of sales, gross profit & growth predictable, recurring revenue Access to capital Quality of financial statements
Ways to Increase Value Financial Opportunity focus on gross profit Asset Risk age and condition it s about reinvestment Product Risk diversification of product line; specialize v. generalist
Reduce Risk Increase Value Market Risk geographic diversification Technological Risk life cycle Regulatory Risk environmental and other reg.
Reduce Risk -- Increase Value Legal Risk eliminate litigation exposure, product liability, employee discrimination Legal Audit: Corporate Records in Order unsigned corporate documents; missing stock certificates
Reduce Dependencies Customer Dependence percentage of total sales >10% Vendor Dependence alternative suppliers Depth of Management key person dependency Quality of Management experience, education, vision, management skills, culture
It s About the People If a particular employee left, what could he or she take that could damage the business?
It s About the People Prevention Employment Agreements Non-compete Agreements Develop functional depth
It s About the People.Motivation Finding, Keeping and Motivating Key Employees Distinguishing between majority of employees and key employees
The Usual Employee Desires: Pleasant work environment Stimulating job Good wages Benefits Job Security
The Key Employee Wants More They think and act like you Eager to be given responsibilities and challenges
The Key Employee Key Employee(s) Want Want to see the business grow and prosper and want to grow and prosper along with the business Take pride in being identified with and contributing to a successful business
Elements of Successful Incentive Program 1. Plan provides financially attractive awards to key employees 2. Plan is specific determinable performance standards 3. The plan is structured to increase the company s value 4. Incentive reward is vested-payment linked to tenure 5. Program must be thoroughly understood
Guard Ownership Cash bonus plan may be sufficient incentive Must have provisions to buy back the stock Determine the mechanism for fixing the value of stock in the event of repurchase Minority owners have substantial rights Is employee critical now and likely to be later (or a hindrance later)?
If you don t know the value of your company, I ll steal it from you and it will be ethical, legal and moral. If you know the value of your company and can justify it, I ll be perfectly happy to pay every nickel of it. --Warren Buffett
In Summary Know the value of your business Evaluate your business s success based on increased value in your investment.
In Summary Not all businesses are transferable Different buyers will pay different values for the same business A company s financial statements do NOT reflect its value Rules of thumb are dumb don t use them
You ve Got Questions We ve Got Answers!
Cathy J. Durham President Capital Valuation Group, Inc. cdurham@capvalgroup.com 608-257-2757 Website: www.capvalgroup.com