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Business valuation … more than meets the eye

By Gregory A. Harr, CPA, ABV, CEPA

As a CPA firm that specializes in all things planning (tax, business valuation, succession), it’s always nice when one of our clients approaches us about establishing an exit plan. Often, we have to push these discussions along, as business owners tend to drag their feet about certain aspects of the process. You may know this intimately; it’s human nature. As an owner, you’re often so close to and entrenched in the business that you founded (or that may represent your family’s legacy), it can be difficult to separate yourself from it.

We always appreciate when owners not only acknowledge the importance of proactive discussions, but also take action. But what caught me somewhat off-guard was when this particular business owner told me he wanted to wrap up the exit planning in two months. This is curious, because the business valuation process alone takes at least one month. And the business valuation process, along with strategies to enhance the value of the business, are cornerstones of a successful business transition. Business valuations are, largely, an essential part of buy-sell agreements, sales and acquisitions, and estate and gift planning. Yet, as with the development of broader exit or succession plans, determining the true value of one’s business remains enigmatic for many owners.

Consider this: In the Exit Planning Institute’ s 2019 “The State of Owner Readiness” report, which surveyed Nebraska business owners, only 19% of respondents had their enterprises formally valued. So, few owners have their businesses valued, despite having access to a wealth of reliable information and planning resources.

I represent one of those resources. I’m among those CPAs and business valuation professionals to have earned professional designation as an ABV (Accredited in Business Valuation). And I can also attest to the abundance of sources that are available to compare one’s business to “peer” businesses, a step in the process of appropriately “valuing” entities.

Why don’t more owners engage with professionals to “value” their businesses?

There are a number of factors at play, some of which may require introspection on the part of the business owner. The Exit Planning Institute, which certifies exit planning advisors like me, cites a large body of past research in its “owner readiness” report. Much of what they cite are the things that we’ve heard from business owners, or perhaps you’ve heard much of the same from a family member, colleague, or friend – “We know how much our business is ‘worth.’” “We don’t need to have our business formally valued.” “We’ve conducted our own research already.” These very sophisticated and successful entrepreneurs are basing something so critical to their livelihoods (and that of their family members and others who depend on the business) to “gut” feelings, or even hearsay.

If all of this sounds familiar, it may hit home or touch a nerve. We must find a balance between sheer numbers and, perhaps, the less quantifiable indicators of a business’s value. Gut feelings alone or questionable estimates that are not based on a defined process are notoriously unreliable; in fact, the Alliance of Merger and Acquisition Advisors (AM&AA) found that 95% of M&A professionals said that the No. 1 factor behind deals falling through was the owners’ “overestimation” of the value of their businesses.

“Price is what you pay. Value is what you get” – the “Oracle of Omaha”

When it comes to getting the price that you want when you go to sell your business, building an operation with “transferable value” is key. But there is often a disconnect between how owners perceive that value, and the “true” figure that is derived from analysis and a process. As an owner, it’s natural to focus on sales and income, without differentiating between and giving equal attention to business value. The focus should be on maximizing a business’s value, not income, and ideally strategic analysis and a plan to enhance value comes into play, which requires some foresight. Income alone doesn’t make for a highly-valued business. The business still has to be attractive and have a level of readiness before it can be transferred as a highly-valued asset.

Additionally, business valuation and buy-sell agreements go hand-in-hand. Yet, the EPI notes only 46% of owners in the Nebraska report had a documented contingency plan and, of the multi-partner businesses, 67% didn’t have a buy-sell agreement at all. Moreover, only 41% of those agreements were recently reviewed. Even if you don’t anticipate changes, it’s important to establish and go over these documents at least once a year with us, your qualified business valuation professionals.

The Business Valuation Process: More Than Meets the Eye

The value of any business is principally based upon its cash flow. We see lots of “mom and pop” companies where you have to be able to sit down, analyze the business thoroughly, get to know how they operate (and their performance as compared to their peers), and determine what is personal in nature and needs to be added back to their cash flow. It can’t be said too emphatically; tax returns and financial statements don’t always give you a true picture of the “worth” of your business.

At O’Donnell, Ficenec, Wills and Ferdig, we take great pride in getting to truly know our clients and their businesses – beyond the “numbers” or what a few documents might say about the perceived health and value of their business. We truly like to live the notion of Certified Public Accountant as the “Doctor of Business.” We keep our fingers on the pulse of their operations in general, a holistic and consultative approach that is, true to our tagline, “more than accounting.” We also like to say that our clients can benefit from the security of our experience, and the excellent partners that surround us and make up an owner’s broader advisory team. That said, the experience from doing this for north of 40 years (in my case) and almost 70 years (firm-wide), helps to provide a basic framework for each “project” that we interface with the client on. So, there are some aspects of the valuation process that we certainly have down to a “science.” The “art” part comes into play when we take a deeper dive into each owner’s operations and respective industries/market “space.”

Generally, as part of determining the value of your business, our client-partners can expect that we’ll:

  • Review and account for five years’-worth of tax returns and financial statements

  • Compare information about the business to their peer businesses, based off of information that can be obtained from various sources

  • Consult with you, discussing variances and “quizzing” about aspects of the business, such as functions and what is unique about your operations

  • Explore additional factors, like equipment and your specialty area in an effort to learn more about the business that can’t be conveyed with analytical work alone

So, while we may have a basic framework or formula, there is absolutely nothing that is “standard” about the work that we do to value a client’s business. Because there is nothing “standard” about our clients! We partner with the owners of salons and manufacturing facilities, and the leaders behind health care and dry-cleaning firms alike. Even within the same “space,” there are tremendous nuances. No one else has your firm’s history, its “story,” the qualitative factors that appeal and endear to the next-generation of owners or buyers. You can’t just take the quantitative “stuff,” the numbers, and start generating the value from there. It’s about getting to know each entity below the surface, getting to the heart of what makes each operation tick.

The power of a properly-valued business

The EPI reports that 80 to 90% of an owner’s net worth is tied to their business. Additionally, of that business’s wealth, 70 to 80% is tied to intangible assets. When one looks at the income recorded on their income statements, does it reflect the true cash flow benefit that is assumed by the owner (or future ownership)? The answer is often “no,” when owners take into consideration normalized income and expenses, discretionary expenses, and nonrecurring charges. The balance sheet, too, may not reflect the true market value, which represents the recorded business assets – and doesn’t account for those intangible assets.

PricewaterhouseCoopers, by way of the EPI study, found that 75% of owners regretted the decision to exit their businesses, and that regret is often linked to a failure to plan. The research also indicates that owners realize they should have integrated a process to accelerate and maximize the value of their business much earlier. It’s only after the fact that it dawns on them that money has been left on the table, again because they didn’t maximize the value of their business at the time of the exit. So, a failure to plan doesn’t always result in something as dramatic as “shuttering” the business. But it can have a dramatic impact on how financially secure and independent you and your family feel about life after the business, and in your ability to maintain the standard of living that you’ve come to enjoy.

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