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BUSINESS VALUATION AND MAXIMIZING COMPANY VALUE

IRS Definition of Company Value. A business is worth what a willing buyer will pay to a willing seller. Valuation Approaches. Rule of ThumbIRS Rulings-Excess Earnings/Treasury MethodAICPA Statement 2008. Common Features of all Methods. Must have an understanding of the business, including histor

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BUSINESS VALUATION AND MAXIMIZING COMPANY VALUE

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    1. BUSINESS VALUATION AND MAXIMIZING COMPANY VALUE Presented by Mike Sowinski, CPA CFO Consultants mike@cfoconsultants.net 828-712-2913

    2. IRS Definition of Company Value A business is worth what a willing buyer will pay to a willing seller

    3. Valuation Approaches Rule of Thumb IRS Rulings-Excess Earnings/Treasury Method AICPA Statement 2008

    4. Common Features of all Methods Must have an understanding of the business, including history, industry, financial data, prior sales and market price of similar businesses Valuation will be impacted by non-financial matters

    5. Valuation Approaches Rule of Thumb Benchmark (like 3X cash flow) Used extensively by business brokers Don’t have to be responsible for the number and usually overvalue the company due to motivation Used by valuation experts for comparison purposes only

    6. IRS Ruling If you CAN’T obtain market value, then you can use this formula Method is called “excess earnings” or “treasury method” Developed in 1920

    7. Treasury Method Steps Appraise the net tangible assets and liabilities Estimate the future normalized income Determine the average expected return on the net tangible operating assets Calculate the excess earnings

    8. Treasury Method Steps Capitalize the excess earnings Determine the value of the business using the appraisal value of all net tangible assets and the capitalized excess earnings

    9. Treasury Method Formula Normalized Future Earnings MINUS: Normal Return on Net Tangible Assets EQUALS: Excess Earnings DIVIDED BY: Cap Rate EQUALS: Intangible Asset Value PLUS: Net Tangible Asset Value EQUALS: Total Value of Business

    10. Formula Definitions Normalized Future Earnings The past earnings to which the formula is applied should fairly reflect the probable future earnings. Ordinarily, the period should not be less than five years, and abnormal years, whether above or below the average, should be eliminated. If the business is a sole proprietorship or partnership, there should be deducted from the earnings of the business a reasonable amount for services performed by the owner or partners engaged in the business

    11. Formula Definitions As a practical matter, the valuation analyst will add back any items that would change when purchased. Common items include Excessive owner compensation and family impact Depreciation and other non cash items Non recurring items

    12. Formula Definitions Normal Return on Net Tangible Assets The percentage return on the average annual value of the tangible assets used should be the percentage prevailing in the industry involved at the date of valuation, or (when the industry percentage is not available) a percentage of 8 to 10 percent may be used.

    13. Formula Definitions As a practical matter, the cost of capital for the company is used as long as it is higher than the industry average net return

    14. Formula Definitions Capitalization Rate The 8 percent rate of return and the 15 percent rate of capitalization are applied to tangibles and intangibles, respectively, of businesses with a small risk factor and stable and regular earnings; the 10 percent rate of return and 20 percent rate of capitalization are applied to businesses in which the hazards of business are relatively high. The above rates are used as examples and are not appropriate in all cases. In applying the “formula” approach, the average earnings period and the capitalization rates are dependent upon the facts pertinent thereto in each case.

    15. Formula Definitions As a practical matter, the IRS’s information is outdated and can only be used as a guideline based on the valuator’s experience and results from other methods

    16. Impact on Cap Rate Lack of marketability Lack of ownership control Premium for ownership control

    17. Formula Definitions Net Tangible Asset Value (Cash, AR, Fixed Assets, Inventory Less AP, Debt etc.) Usually arrived at by specialist appraisal or some other logical method

    18. AICPA STATEMENT Statement of Standards for Valuation Services #1 In effect January 2008 Lists information to be reviewed and considered before assigning value Considers business valuation and intangible asset valuation separately

    19. AICPA STATEMENT For business and security valuations, valuation analyst should consider the three generally accepted approaches Income Approach Market Approach Asset-based approach

    20. INCOME APPROACH Discounts “normalized” earnings based on an interest rate adjusted for risk Can be past or future

    21. VALUATION CONSIDERATIONS-INCOME APPROACH Normalization adjustments Nonrecurring revenue and expense items Income taxes Capital structure and financing costs Capital investments Noncash items Qualitative judgments for the risks considered to compute the discount and/or cap rate Any expected changes in future economic benefits

    22. VALUATION CONSIDERATIONS-INCOME APPROACH Any forecast/projection valuation variable assumptions The forecast/projected earnings and/or cash flow Estimation of the terminal value

    23. MARKET APPROACH Public company information Historical sales of similar companies

    24. VALUATION CONSIDERATIONS-MARKET APPROACH Qualitative and quantitative comparisons Arm’s-length sale/license transactions and prices Dates and consequent relevance of empirical market data

    25. ASSET APPROACHES Adjusted Net Asset Method Determines fair value of all assets and liabilities, difference is net value (Lawyers like this one) Excess Earnings Method

    26. VALUATION CONSIDERATIONS-ASSET BASED APPROACHES The existence and value of tangible and intangible assets, as well as both recorded and contingent liabilities Asset liquidation costs, as appropriate

    27. MAXIMIZING VALUE As a practical matter, the adjusted net assets method is not often used in buy/sell transactions All other methods place part or most value on excess earnings Asset value and historical cost are also important

    28. GENERATING EXCESS EARNINGS Concentrate on net cash flow rather than sales Remember that owner compensation is generally an add back Grow cash flow every year, particularly in the last 5 years prior to sale Use forecasts during negotiations

    29. GENERATING EXCESS EARNINGS Track ratios and be sure to increase each year Do better than industry averages Use budgets to drive sales higher and costs lower

    30. MAXIMIZING CAP RATE Organize the business’ financial records Clean / repair equipment Normalize inventory Clean up the financial statements and internal controls

    31. MAXIMIZING CAP RATE Have policies and procedures in place Clean up any litigation matters Watch terms on leases, loans, insurance, supply contracts, debt covenants etc...

    32. MAXIMIZING CAP RATE Have a good attorney and CPA ready, have financial information in a timely manner, and have all agreements in writing Make decisions based on financial information rather than gut feeling

    33. MAXIMIZING CAP RATE Be “transparent” throughout the process Know your industry, competitive environment, and possible subsequent events

    34. Components of a Summary Valuation Report Identity of the client Purpose and intended use of the valuation Intended users of the valuation Identity of the subject entity Description of the subject interest

    35. Components of a Summary Valuation Report Subject interest ownership characteristics and degree of marketability Valuation date Valuation report date Type of report issued (a summary report)

    36. Components of a Summary Valuation Report Applicable standard of value (rule, principal, measure) Applicable premise of value (assumptions) Sources of information used in the valuation Any assumptions and limiting conditions

    37. Components of a Summary Valuation Report Any restrictions/limitations on the scope of work or the data availability Any hypothetical conditions assumed Description of any specialist’s work relied on and the level of responsibility valuation analyst assumes for specialist’s work

    38. Components of a Summary Valuation Report Valuation approaches and methods used Reconciliation of value estimates and conclusion of value Disclosure of any subsequent events Any jurisdictional exception Representation of the valuation analyst

    39. Components of a Summary Valuation Report Signature of valuation analyst or analyst’s firm Statement that the valuation analyst has no obligation to update the report

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