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Business Valuation - Part I

After deciding to buy or sell a business, the subject of "how much" becomes important. Determining the value of a business is one of the most difficult aspects of any transaction, since every business is unique.

A common misconception is that valuation is an exact science. While the use of formulas in a valuation implies exactness, it is very difficult to set a worth of a company at a single figure. To establish a fair market value, "hard" figures, such as assets, liabilities, and historical earnings and cash flow are used. But "soft" or subjective figures, such as projected earnings, future cash flow, and the value of intangibles (such as patents, know-how, the quality of management, and leases at below market rates) are used as well. Soft figures can also include such considerations as current market conditions, industry popularity, and, most important, the objectives of the seller or buyer. With all this subjectivity, fair market value can be at best only a range of estimates.

A second misconception is that value equals selling price. The final selling price can be either higher or lower than the estimated range of values for the company, depending on the eagerness of the buyer to buy and the seller to sell, the demand for the type of company, the form of the consideration paid, the negotiation skills of the parties, and so forth. In fact, the selling price of a company sometimes does not seem to have much relation to its estimated value.

Ask appraisers the value of your business and they will respond, "What's the purpose of the valuation?" Valuation methods-and therefore values-vary according to the reason for the valuation. Different techniques can be used to arrive at different values, and each of the values may be correct for the specific situation. For purposes of this discussion, we will focus on the valuation techniques used for buying a company as a going concern.

Whichever technique is used, the valuation comprises these key elements: gathering information about the company; recasting the historical financial statements; preparing prospective financial statements; comparing the company's results with those of other companies in the industry; and, finally, applying appropriate valuation methodologies.

Gathering Information

The selling memorandum, the basis for the buyer's preliminary evaluation of the company, should contain comprehensive information about the company, its history and operations, and its market position. The buyer will continue gathering all the information he can about the company through such sources as management interviews and conversations with the company's vendors and customers.

Buyers will also want to gather similar information about competitors of similar size. In addition, buyers may want general information about the industry and the industry's leaders to help them understand market trends, competitive strategies, and the dynamics that cause companies in this particular industry to grow and succeed. Potential sources for industry and competitor information include market studies, reports of trade associations and credit rating agencies, and annual reports and stock analysts' reports of publicly owned companies.

Recasting the Financial Statements

The historical financial statements may need to be adjusted to make them more meaningful or to compare them with those of the company's competitors. For example, take the financial statements of a closely held or family business whose objective in years past has been to minimize earnings to minimize corporate income taxes. To achieve this, the company may have awarded unusually large bonuses to employee-owners, masking the "true" earning power of the company. As the buyer or seller, you want to recast, or normalize, the financial statements to account for this kind of activity.

In valuing a business, some typical income-statement adjustments may include the following:

  • Excessive management salaries
  • Salaries paid to individuals who can be replaces at much lower salaries
  • Retirement and health plans that provide better benefits than the plans of other companies in the industry
  • Excessive perquisites such as company cars and club memberships
  • Favorable or unfavorable leases
  • Last-in-first-out (LIFO) inventory adjustments
  • Interest rates, if the buyer borrows at significantly different rates
  • Adjustment of sales to reflect selling price increases, in cases in which prices have not been increased recently and such increases would not have affected sales level
  • Nonrecurring expenses, such as legal expenditures, relocation costs, and casualty losses
  • "Window dressing," or practices that temporarily improve current earnings. For instance, a company right reduce necessary long-term investments such as research, advertising, or maintenance, improving its current earning but weakening its potential for future earnings.
  • Tax rates. If the company has an unusual tax situation, such as available net operating loss (NOL) carry forwards, an adjustment should be made to reflect "normal" taxation.

In valuing a business, some typical balance sheet adjustments may include the following:

  • LIFO reserves, to adjust to inventory to current cost
  • Undervalued or overvalued marketable securities and investments in unconsolidated subsidiaries
  • Fixed assets that have appreciated in value
  • Intangible assets that may be recorded on the books
  • Beneficial leases
  • Assumable debt with favorable interest rates or repayment terms
  • Unrecorded pension and other postretirement liabilities
  • Contingent liabilities

After identifying and quantifying applicable adjustments, you will have a more meaningful set of financial statements to use in making financial projections and in comparing the company's performance with that of other companies.

Projecting Earnings

Prospective financial information should be prepared for the next three to five years. The seller will probably have already prepared this information for its own purposes and included portions of it in the selling memorandum. However, the chances are that the buyers will want to do their own analysis.

Prospective earnings may be estimated in one of three ways:

  • Use an average annual growth rate derives from the past three to five years' income as an estimate of future annual earnings. This method assumes that the earnings trend will remain essentially unchanged and, therefore, that historical earning are a valid indicator of future performance. The major disadvantage of using average historical growth rates is the past conditions may not remain the same in the future. Because business conditions are constantly changing, you should adjust for known and anticipated changes.
  • Use an estimate of future earnings under the current owner's management, adjusting for inflation and industry trends. This method of defining future earnings assumes that, after the sale, management will continue to operate the company in the same manner as past management and with the same degree of success.
  • Use an estimate of future earnings under the new owner's management, adjusting for inflation and industry trends. This method is probably more useful to the buyer than the seller. It analyzes the effect that new management or strategies will have on future earnings. These effects include changes in marketing strategy, manufacturing technology, and management philosophy.

Comparison with the Industry

Before proceeding to the valuation, the company's results, as restated, should be compared with the results of other companies in the industry and with the industry in general. Some of the comparative analysis should focus on the following figures:

  • Sales growth
  • Gross margin
  • Earnings before income taxes, as a percentage of sales
  • Earnings before interest and income taxes, as a percentage of sales (this eliminates the financing bias)
  • Earning before depreciation, interest, and considerations can also play major roles in structuring a transactions and should be carefully analyzed as well.

The Buyer's Issues

The buyer will want to structure the sale to reduce the after tax cost of acquiring the business. Consequently, a primary concern will be the allocation of the acquisition cost. The buyer will want this cost to be allocable to assets that can be expensed or depreciated quickly for tax purposes. The business may also have net operating loss (NOL) or tax credit carryforwards that the purchaser may want to preserve for future use.

To the extent that the transaction can be structured to allocate the acquisition cost favorably or to preserve carryovers or minimize the restrictions on their future use, the buyer may be in a position to pay more for the business.

The Seller's Issues

The seller, on the other hand, will want to structure the sale so as to minimize the taxes on the gain. If the seller provides financing by accepting payments in installments or by accepting the purchaser's stock, the seller will want the transaction structured so that the tax to be paid on the gain is delayed until the receipt of the installment payments or the sale of the stock receive.

A second related issue is the character of the gain (whether it is capital gain or ordinary income). The tax rate on capital gains is less than the tax rate on ordinary income, making characterization as capital gain desirable.

Sale of Stock Versus Sale of Assets

What will be sold-the individual assets of a business or the stock in the corporation that operates the business? For the buyer, this decision determines the tax basis of the assets of the acquired business. For the seller, this decision can affect not only the absolute amount of the gain, but its timing and character as well.

As the sale of stock causes no change in the legal entity, the tax basis of the corporation's assets remains unchanged, and all the corporation's tax attributes (for example, tax elections, tax year and method, and tax carryforwards) are preserved. Existing carryforwards are available to the purchaser.

With an asset sale, the corporation's tax identity does not transfer to the purchaser. The acquired assets have a new tax basis equal to the purchase price, and NOL carryfowards and other favorable tax attributes are not available to the purchaser.

Except for the sale of a subsidiary, the tax implications of a stock sale are fairly straightforward. The selling shareholder's gain or loss is the difference between the amount received on the sale and the shareholder's tax basis in the stock. Generally, the tax basis in the stock is the amount that the shareholder initially paid for the stock.

The seller's tax basis in the company's stock (the "outside" basis) is typically different from the company's basis in its assets (the "inside" basis). If shareholders expect to recognize a substantial gain on the sale, they will usually want to structure the transaction as a stock sale rather than as an asset sale.

This is because the gain from the asset sale is taxed twice-the corporation pays tax on the gain from the sale of its assets (the "inside" gain). And the shareholders of the corporation pay taxes again (on the "outside" gain) when the net proceeds are distributed to them. A comparison of an asset sale (Fig.1) with a stock sale (Fig.2) illustrates this difference. In this example, as result of this double taxation, the sellers are able to retain only approximately $6.5 million of the $10 million sales price.

Shareholders' Net Proceeds from the Sale of Corporate Assets

The purchaser is willing to pay $10,000,000
The corporation's tax basis in its assets is $3,000,000
There are no corporate liabilities
The corporate tax rate is 34 percent
The shareholders' tax basis in their stock is $2,000,000
The shareholders' personal tax rate is 20 percent

If the corporation sells all its assets, liquidates, and distributes the after-tax proceeds of the sale to its shareholders, the shareholders will have the following cash left after paying taxes;

Tax on corporate gain:
Proceeds from sale of assets
Net assets
Corporate gain
Tax rate
Tax on corporate gain

Tax on shareholders' gain
Liquidation distribution to shareholders
Shareholders' tax basis
Shareholders' gain on distribution
Tax rate
Tax on shareholders' gain
Net proceeds

Shareholders' Net Proceeds from the Sale of Stock

Tax on shareholders' gain
Proceeds from sale of stock
Shareholders' tax basis
Shareholders' gain on sale
Tax rate
Tax on shareholders' gain
Net proceeds

If the outstanding stock of the corporation is sold instead, only one level of gain is taxed currently-the shareholders' taxes on their capital gain. As Figure 2 illustrates, the sellers save approximately $2,000,000 in taxes by selling stock rather than assets.

From the buyer's perspective, however, the purchase of stock means the purchaser in the example will continue to have the old tax basis of $3 million is the company's assets, even though $10 million is paid to acquire the business. If the buyer had bought assets instead, the value of the acquired assets could have been "stepped up" to their purchase price of $10 million.

What does this absence of a "step-up" due to a stock purchase cost the purchaser? If the appreciated assets (for example, equipment, inventory, or receivables) have short lives or if the purchaser intends to liquidate the corporation or to sell some of the appreciated assets in the near future, the lower tax basis may result in a significantly higher future tax liability for the purchaser. However, if the corporation's assets either are nondepreciable (as with land) or have relatively long lives (as with buildings), the failure to get a step-up in basis may not result in materially higher taxes for the purchaser in the near future. This being the case, the purchaser may be willing to purchase stock rather than assets if the structure is accompanied by a reduction in the price. In the case above, if the sellers receive more than $8,120,000 for the stock they will have more after-tax proceeds than from a $10,000,000 asset sale. Consequently, room exists to negotiate to the advantage of both the buyer and the seller.

A stock sale could actually be advantageous to the purchaser if there are corporate attributes worth preserving. This usually occurs if the corporation to be acquired has NOL or tax credit carryforwards that can be used by the parent. However, be careful of certain restrictions that can be imposed upon the use of carryforwards.


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