Goodwill, Blue Sky, Pie in the Sky, all the same!

3 08 2012

 

 

 

Wait a minute there is a huge difference.  Assume for instance you are a famous scientist that just made a machine that would make pure gold and the cost of the machine was $20,000. How much would someone pay for this machine. I am willing to bet it would be more than $20,000. But how much more, is the Appraisers dilemma.  Well the first thing to decide is how much production is it capable of and secondly how long will the machines run. All machines need maintenance and surely as sophisticated as this one is, what will that cost?

 

 Where will we get the parts, are they available and how expensive would they be? Who is qualified to repair this machine? Is the inventor the only one who could fix it? How long will this genius be around and what will he charge for consulting or repair?  Oh no, what if this ability to make pure gold is illegal and if not how 

 

long before Uncle Sam decides you are ruining the economy and passes 

 

laws to stop your production? But wait, maybe they would want to buy 

 

it. Oh my God, how much more would Exxon pay? Forget Exxon, what about 

 

Germany, no wait, the Chinese or Russians? However, the Saudi’s have 

 

all the cash. Hmmmmm

 

 I wonder what the value of this machine is now.  I would bet millions or even billions. What do we call this increase in value? Is this blue sky?  Is this increase in value really real?  Surely not, since the SBA is only willing to loan $20,000 plus one half of this so called blue sky, and not to exceed $250,000.  Maybe with this thinking a buyer should forget this machine as it is obviously risky with all that goodwill and purchase another machine that only has cash flow that will support a loan of $40,000.

 

 I think you can see by this silly scenario that there is goodwill. A business should be looked at the same as a money machine.  The appraiser needs to study the company to find its strengths and weaknesses and calculate risk. Based on its current operation what does the future hold for this business? Will future government regulation slow down or end the cash flow?  What about the company’s suppliers, is cost going to increase; is there other suppliers the company can buy from or are is the company at the mercy of a single supplier. As stated above, all machines need repair, so what kind of condition is the equipment in and how old is it.  Does the seller have a good reason for selling his or her business? How hard will it be for a new owner to fill his shoes?  It’s good to hear that the workforce has been with the company for years with hardly no turnover and that these excellent employees and managers made the company grow throughout the years, but what is the age of the employees and management?  Are they all going to retire soon? When was their last raise?

 

 

 

Just who are the company’s customers?  Is that one big account that represents over 50% of their business going to buy from the company through ownership change; and are they under contract to buy; or is the customer’s CEO a long time college buddy of our retiring seller?

 

 Another factor in calculating risk is the economy and the company’s trade area.  Based on the foreseeable future, is the company’s product or service going to be negatively affected? 

 

 Salaries and wages are usually the second largest expense after cost of goods. Considering the nature of the business and the degree of technical expertise needed to make the company’s products; is the new owner likely to find new people to replace retiring employees and management; and what will they have to pay them? A shortage of talent is like everything else, the more scarce, the more you have to pay.  Being the second largest expense, and not able to project future costs, means any projections are guesswork, and as we all know, anticipated future earnings is the foundation of all valuation models.

 

 Value has a lot to do with the size of the buyer pool. Is this company such that the technical expertise needed to manufacture, improve, market, and upgrade its product such that only a handful of buyers are qualified; or would it be a perfect fit for the thousands of unemployed managers from corporate downsizing.

 

 Ease of entry plays a big part in value. How hard is it to start up and compete with this company?  If you are successful, one certainty in business you can count on is your neighbor will be selling a close substitute product or worse; one of the huge companies with millions to spend on advertising and marketing will shut you out of the market completely.  If a buyer can open up across the street from the business and make as much money in six months to a year, why would the buyer pay 4 or 5 years of earnings. However, if the buyer was looking at a substantial upfront investment in assets and a 5 hard years to get where the owner is now; knowing he would be constantly shelling out his personal capital to keep his new start up business afloat and receiving no salary during those 5 years, would realize he would be way ahead by paying the 5, 6 or maybe 7 years of earnings because he would start making money the first month, receiving a salary and does not have to compete with the company.

 

 Every question in this article must be assigned a degree of risk.  The compilation of these risk factors determines the capitalization rate or multiple of earnings used to establish the value of the company and determine its goodwill.  

 

The Small Business Administration (SBA) defines goodwill as:

 

 “Goodwill” is created when an existing business is acquired and the acquiring entity pays more for the business than the book value of the business’s assets.  Simply put, “goodwill” is the premium the seller is requiring as part of the purchase price (and the buyer is willing to pay) for an established business in the marketplace as compared to that same buyer starting a new business.  By paying a premium for an established business, the buyer is relying on the existing business’s established market share to continue due to such reasons as an established customer base, a premium location, etc.  (Customer lists and non-compete agreements are documents that the seller may provide to support the goodwill the seller is requesting.) 

 

Therefore, simply stated, it is the difference between what a company will sell for and it’s hard assets.  To get to the price the company will sell for, the appraiser has researched, analyzed, compared prior sales and analyzed a myriad of factors that would contribute to or decrease value.  In the Excess Earnings method, each asset of the business is analyzed as to the return it should earn.  The amount of earnings after this is considered excess and is capitalized to calculate goodwill.

 

In summary, there is a huge difference between goodwill, blue sky, and pie in the sky, because goodwill is painstakingly analyzed, researched, compared to comparable sales and calculated.  Blue Sky and Pie in the Sky are values that are guessed at or just pulled out of thin air so the next time you hear someone using them interchangeably I hope you will correct them.

 

 

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Business valuation, an analysis of risk

3 08 2012

Analyzing risk is the predominate factor in valuing a business.  The appraiser must analyze every aspect of the business and quantify his or her analysis of the company’s risk into value.  A study of the significant risk factors in the business must be identified and then rated as to the degree of risk each carries.  The following are some of the factors to analyze in a business.

 Labor

There are many key factors to analyze as far as labor is concerned. Are employees hard to find? What educational skills or level is required and is the labor pool such that they could be replaced?  If the company is highly technical, there may not be many individuals in the area that have those skills and thus make it difficult for the company to grow. On the other hand, many of these companies can outsource or use virtual offices with employees in any part of the country.

Are key employees and management due a significant salary increase? Again, many employees are faithful to the owner and feel that once the company grows a little more, they will be rewarded both in salaries and advancement.

What are the ages of the employees and key management?  If many of the key managers are close to retirement age, they may just retire when ownership changes. After many years on the job and very close to retirement, many in management don’t want the changes they perceive with new ownership.

What is the liability risk with the employees? Are the jobs they are performing such that accidents are a normal occurrence in the industry?  If this is the case, have the employees been trained sufficiently in safety procedures?  Is safety an on-going program for the employees?  If the company has delivery vehicles, a check of the accident history is in order.

 Management

Will key employees’ stay once the company changes ownership? It is not uncommon for key employees to leave the company for a more lucrative position with a larger competitor.  Many times, the key employees stay with the company  as they are close to the owner and are in a position to contribute to the company’s growth and success and feel they will be rewarded heavily someday.

Has management been efficient?  Are they up to the challenges of the future?  Many companies have employees that grew up with the business but now the company has outgrown them.  They do not have the education or expertise to take the company to the next level. 

How many of the key managers are relatives?  If all or most of the key managers are relatives, and will be gone after the company sells, there is no management.

Who is responsible for the majority of sales? Does the company have a sales force or is the owner responsible for most of the sales and if so, how hard would it be to replace him. 

Financial Strength

Is the company solid or are they in a cash crunch?  Some ratio analysis can tell you what kind of financial position the company is in and how it compares to other companies in its industry.  An analysis of the company’s account receivables is necessary to see how they are getting paid.  An abundance of slow paying customers can drain the company’s working capital.  Insufficient working capital can prohibit the company from growing because it can’t buy enough raw materials or inventory to meet an increase in sales. 

Does the company have the ability to buy from several suppliers or are they enslaved by one that can raise prices whenever they want?  Another question that pops up is how stable is the supplier?  Cost of sales is usually the largest expense for a company.  If you have no idea what the future costs are going to be, you can’t make any kind of meaningful future projections or budgets.

 Facilities & Location

What is the length of the lease? Is it likely to increase? Are the facilities sufficient for the business and possible expansion? What about the company’s location? Are any major roadways or changes in the area likely to affect the company?

 Diversity of Accounts

If the company loses one or two accounts will they be out of business?  Many companies have one account that equals a large portion of their business.  Unless these large accounts are under contract for several years, a buyer may be hard to find.  Will the accounts stay with a new owner is the heart of the analysis for the appraiser.

 Competition

How strong is competition? What is the level of ease of entry into this industry? Are technological changes going to give a major competitor with more cash a significant advantage?

 Predictability

What has the historical financial picture shown? What would it tell a buyer as to what he or she can expect in the future?

 Marketability

How hard would it be to sell this company? How many buyers would be interested in this type of business?  Does the company have a really unique niche? What is the future of its customer base?  Do they manufacture sewing machines or medical equipment?

 Future Outlook

Always remember that a business is bought on the assumption of its economic benefit to its owner. The more stable the financial future, as well as other factors like technological changes, environmental regulations, and public attitude, can have an effect on a buyer’s emotion. This relates to how long the buyer is willing to risk his or her money and therefore how fast he or she would want it back and thus the multiple of earnings he or she is willing to pay.

In business appraisal, value has its basis in “anticipated future benefits” (earnings).  What the company will do in the future is what its value is based on.  The risk factors mentioned in this article are the key to the projections that have to be made in the appraisal process and are all critical points that the appraiser must consider. Image





Business Value Drivers

3 08 2012

Business value drivers are those aspects of a business that can and do add value.

Today’s business environment is not just about survival, it’s about focusing on and creating sustainable value. But, which elements of a business are capable of creating value? Equally important which elements of a business are capable of destroying value? Proper business planning is the process of uncovering and identifying what creates and drives value.

ImageStart by using the SWOT Analysis – Strengths, Weaknesses, Opportunities and Threats – this will help you identify the “value drivers” for your business. With this approach, you can focus on key value drivers.

There are many Value Drivers that have been identified in businesses. But, typically no more than 8-12 are critical in any given business; here are the most common 8.

 

 

Financial History:  

Are your books accurate and up to date? Over the last few years are there patterns of growth or decline? If in decline, are there good reasons for the decline?  Accurate and current financials are important to determine how the company fares in its industry and amongst competitors.  A comparison to industry ratios can identify strengths and weaknesses in the business.

 

Management Depth:

Can the company operate without the owner, for more than a week or two? Is there any cross-trained management to fill in if you were gone?  What is the average age of management?  Will they retire soon? What levels of experience and education do they possess? Having a good management team can add value to the business.

Customer Diversity:

Do you have one or two major customers that account for more than 25% of your gross sales?  What would happen to the value of your company if you lost one? Are most of your customers considered “blue chip”? A good overview and a rating analysis of the customer base can be beneficial not only for added value but is crucial for where, how and when you advertise, not to mention a much better understanding of your accounts receivable and aging.

 

Owner Involvement:

Are you the ‘rainmaker’ in the business? Does everything from sales to

production revolve around you and your decisions? How difficult would you be to replace? The more the business depends on you, the owner, the more likely the value will be lowered.  One of the things I see the most is that over the years, the business owner and number one sales person, is now an office manager.  Maybe it’s time to get back out in the field with your sales people or provide on-going sales training.

Competition:

Does your company compete in a clearly defined market niche which is

defensible? Or, have your products or services become a commodity that is becoming more difficult to defend?

Customer Satisfaction:  

Are your customer relationships based on great products and service, or lowest price? How long and what type of history have they had with you? Are they satisfied or loyal? Do you have systems in place to identify your customers and communicate.

Loyal Employees:

Outside of ownership, are there people in place who you can rely on and are

capable of doing their job day in and day out? Are they considered knowledgeable for your industry? Again, what levels of experience and education do they possess?

What is the average length of employment amongst your staff? A responsible business buyer will be looking for opportunities where the current staff, especially management, will remain in place, following the current owner’s exit from the business. Having key employee contracts, non-competes, but more importantly a loyal, dedicated staff that is committed to the company’s success regardless of ownership change will be highly valuable to a prospective buyer and thus reflected in a business valuation.

 

Proprietary Technology:

Has your company developed a unique application, tool or technology as part of its

Ongoing operations? Does it give you a competitive advantage? If so, this proprietary innovation or intellectual property can be positioned as a key value driver for your business. Technologies or processes do not have to be patented to carry value but privacy and confidentiality must be maintained. It is critical that non-compete and confidentiality agreements be strictly adhered to and enforced by the company, before and after a transfer of ownership. The benefits, application and purpose of your proprietary technology should be explained to a business valuation consultant.

Intangibles (intellectual property) and human resources (who go home at night) can be protected and leveraged through a combination of business strategies and legal protections. Business strategies include incentive compensation plans to recognize, reward and retain high performing employees. Legal protections include requiring key employees to sign non-compete agreements, registering Trademarks and Copyrights, and taking steps to protect proprietary information/trade secrets such as recipes and formulas. Contracts with key players, including partners, customers and suppliers, are also important.

In conclusion, it’s easy to be distracted by all the demands competing for the business owner’s time and attention. To maximize the value and profitability of your company, you need to focus on the key value drivers – which may be intangibles and employees – in addition to having up-to-date equipment and systems.





Measuring Enterprise and Personal Goodwill

3 08 2012

By: George D. Abraham

CEO & Chief Appraiser

Business Evaluation Systems

 

 

In the state of Texas and several other states, appraisals for divorce, requires the appraiser to consider and analyze personal and enterprise goodwill in the dissolution of marital assets. Personal goodwill is not considered part of the marital assets to be divided.

The American Journal of Family Law states that Goodwill is “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.[1]  It can be separated into two parts, defined as follows:

  • Personal goodwill is the value of earnings or cash flow directly attributable to the individual’s characteristics or attributes.  Personal goodwill, sometimes referred to as professional goodwill, is a function of the earnings form repeat business (customers) that will patronize the individual practitioner as opposed to the business, new consumers who seek out the individual, and new referrals who will be made to the individual. 

 

  • Enterprise goodwill is the value of earnings or cash flow directly attributable to the enterprise’s characteristics or attributes.  Enterprise goodwill, sometimes referred to as practice goodwill is a function of earnings from repeat business (customers) that will seek out the business (as opposed to the individual), new consumers who will seek out the business, and new referrals who will be made to the business.

Most appraisers approach the allocation by simply dividing the attributes into personal and enterprise, but you can take it one step further which offers a reasonable position if challenged and provides a consistent method and a defensible bases for your opinion.  

Once the appraiser has a solid goodwill value, the analysis of personal and enterprise goodwill can begin by analyzing the attributes that make up goodwill. The appraiser must keep in mind that the process requires several key factors:

  • The attributes that impact personal goodwill are a percentage within a range.
  •  Enterprise goodwill is the reciprocal percentage.
  • Does the presence of this attribute add to the earnings of the business? The greater the impact on earnings, the greater is the presence of the attribute.
  • The difference between total goodwill and personal goodwill is the enterprise goodwill.

Goodwill Attributes

Personal Attributes

These are attributes that relate directly to the ‘goodwill subject”. This is the person for whom the goodwill allocation is being performed (physician, architect, accountant, etc). Personal attributes reflect the efforts by the goodwill subject and are inherent in the individual.  These personal attributes indicate personal goodwill, including:

 

 

  • Ability, Skills, and Judgment.  These attributes focuses on the “doing” by the goodwill subject;        e.g., the ability to perform at a level to generate sufficient earnings to establish goodwill.  The            goodwill subject’s education, training and demonstrated ability will almost always be important             personal attributes.

 

  • Age and health.  These are significant as they help determine the longevity of the subject’s   impact on earnings. Underlying all value is the time frame for cash flow or earnings.  Older and less healthy subjects could mean a shorter and more uncertain stream of future earnings, and      thus, a lesser personal goodwill allocation.

 

  • Personal Reputation. This is the customer’s perception about the person’s ability, skills and judgment.

 

Business Attributes

These are the result of decisions that affect the business organization, operations, finances, and image.  If the goodwill subject makes decisions that improve enterprise attributes, this increases enterprise and not personal goodwill. Examples of business attributes to the enterprise include:

  • Location, location, location.  There is a multiple location attribute and the business location attribute. Keep in mind that multiple locations do not mean a strong indication of enterprise goodwill. The appraiser must understand how the locations are being used.

 

  • Systems and organization.  This encompasses the management decisions that determine how the business performs. These are well defined and maintained systems that make the business strong are a good indication of enterprise goodwill, even if the goodwill subject created the systems.

 

  •  Business reputation. If the customer’s perception about the product or service, including price, customer support, quality and satisfaction are on the business, the characteristic is enterprise.  In some cases the customers commonly associate a business with an individual, but it is the business reputation they are counting on.  Keep in mind that some businesses have both personal and enterprise attributes that the appraiser must separate and analyze.

 

  • Staffing. Staffing encompasses all the employees of the business, other than the goodwill subject. Usually employees are associated with enterprise goodwill, but there are times when employees may seek a position because of the personal reputation of the goodwill subjects training that would add value to their own resume.

 

  • Personalized business name.  This is the most misunderstood attribute as it is automatically assumed that if the business carries the subject’s name, all is personal goodwill. However, many businesses are sold and carry on with the personalized name and others change the name sometime after the purchase. The question to address is:  “Would the customers abandon the business solely because it changed its name?”
  • Closeness of contact. Sometimes the goodwill subject’s work habit includes more contact with the customer, and the more direct contact, the more likely the subject will have personal goodwill. (Dentists have close contact, while radiologists do not.) However, it is not so much the closeness of the contact as it is the personal nature of the contact.

 

  •  Closeness of contact. Sometimes the goodwill subject’s work habit includes more contact with the customer, and the more direct contact, the more likely the subject will have personal goodwill. (Dentists have close contact, while radiologists do not.) However, it is not so much the closeness of the contact as it is the personal nature of the contact.

 

  • Referrals. Referrals to a goodwill subject often indicate a high level of respect for one’s abilities and are personal in nature and increase the individual’s personal goodwill. However, referrals can certainly be made to a business and those referrals would support a greater enterprise allocation.
  • Repeating revenue stream.  This attribute deals with the specific nature of the revenue stream and is the heart of goodwill. Repeating business can be due to either enterprise or personal goodwill.  However, some businesses are more likely to enjoy repeat business by the nature of their industry and are not concerned with the reason for the repeating business, such as a great location.

 In summary, the appraiser will analyze and separate each of the attributes into personal and enterprise goodwill by establishing a range with each attribute weighted according to its importance (impact on earnings).  Each attribute is then given a weighting as to its degree of existence.  The value of an attribute established by multiplying the degree of existence by the degree of importance represents a percentage of  100%.  As personal goodwill increases, enterprise goodwill decreases by the same amount. 

 


[1] Article: An Allocation Model for Distinguishing Enterprise Goodwill from Personal Goodwill,” American Journal of Family Law

 

 

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Comparing Comparables

3 08 2012

Comparing Comparables 

By: George D. Abraham CEO & Chief AppraiserImage

Business Evaluation Systems  

The Direct Market Data Method (DMDM) relies on the principle of substitution. A buyer will not pay more than the price at which he can obtain an equally desirable substitute.

 

The DMDM method uses parameters of comparison in the form of income multipliers.  They can be multipliers of income, either gross net or discretionary cash flow.  The three most popular databases which supply the transactional data are; Institute of Business Appraisers (IBA), BizComps and Pratts Stats.

 

When attempting to value a company using the Direct Market Data Method (DMDM), it is not uncommon to experience a wide range in value between the Price to Discretionary Earnings (P/E) and Price to Sales (P/S). In using the transactional data, one must remember that we are comparing businesses and in most cases, these are complex entities.  Unlike real estate, whereby land and improvements can be measured fairly accurately using a comparison of price per square foot, businesses are much more complex and have many variables that can have a significant impact on value. There are several reasons for the wide ranges that occur between the two multiples when using the databases.

 

The three databases obtain their data mainly from business brokers and other intermediaries.  The reporting systems for each of the databases are not standardized and some are limited regarding details of the transactions. The fundamental problem in collecting data is the reporting forms supplied to collect the data.  Business sale structures can be very complex, forcing the broker to elaborate on the form in order to describe the input, especially when it comes to the selling price.  Many sales contain exchanges, earn-outs or an additional price based on some contingency and forces the business broker to elaborate when the reporting the selling price of the business. The person inputting the data into the database is faced with deciding the selling price.   Unfortunately, the industry lacks consistency in common terms such as owner’s discretionary cash flow and net income (before or after tax).  The BizComps database removes the inventory from the selling price, but many times sales include inventory and is not mentioned or if mentioned, no inventory value is given.  Inventory values given to the other databases and included in the price, have usually not been valued or even counted for accuracy. In my experience, the Sellers value of the inventory is almost always incorrect as it does not include adjustments for slow moving, never moved or dead inventory. Adding to the dilemma on inventory is FIFO and LIFO accounting.

 

The sales contained in the databases were sold as asset sales and generally do not include current assets or liabilities, but many times to make the sale, the owner will include the receivables and/or allow the buyer to assume some of the liabilities.

 

Another problem with reporting the sales consistently are real estate and improvements.  Companies in the databases do not include real estate and improvements and a fair market rent has been deducted from the company’s earnings, but was the rent used really fair market?

 

Location of business is given only in terms of general geographic area which could have a significant effect on value for some businesses whereby location is paramount to success.

 

In other cases, the sales with high multiples are not arms length and the business was purchased based on acquiring a valuable location or a competitor paying over market value to eliminate a major competitor.  As many Baby Boomers are retiring, they are transferring the businesses to sons and daughters and these may also not be at arm’s length.

Another problem, which in my mind is significant, is that prior revenues and earnings are not provided. Without a history of the company’s historical performance we do not know if the Company was in rapid decline or significantly increasing in revenues and earnings. Despite the reporting problems inherent in the databases, if analyzed correctly, the data is very valuable. The least it can do is set a range of multiples that you can narrow down. 

Business appraisers will sort the sales in the databases according to revenues and then choose a group which contains sales that are close to the company or a sales range which would not change the operating ratios significantly.  Once the comparable group is established, the companies in the group need to be carefully analyzed to their closeness to the subject company.  Companies whose sales to earnings ratios are significantly different than the subject should be discarded. A close look at the location should be made if that is important and the date sold.  I think it is safe to say that most people feel that there was a world of difference in business after the beginning of 2009.  However, before you form this conclusion in your analysis, take into consideration that all values are derived from anticipated future performance.  As we all can remember, interest rates were extremely high back then and required return on investment had to compensate for this, this and the higher the return required, usually the lower the value.  Currently interest rates are at an all time low and the required return is much lower so in some cases the older sales may not be that different.