Business operations are subject to a number of internal and external risks, as are ownership interests in businesses. How organizations and their owners address these risks can have a significant impact on the value of businesses and interests therein.
“An enterprise risk management process involves identifying risks relative to an organization’s objectives, assessing them for likelihood and impact, developing a response strategy and monitoring progress,” says John T. Alfonsi, managing director at Cendrowski Corporate Advisors.
A well-defined enterprise management process (ERM) framework can protect and create value for organizations and their owners, he says.
Smart Business spoke with Alfonsi about ERM to better understand its applications.
Where is risk addressed in a business valuation?
The most common method of valuing a business is the ‘income approach,’ which requires a valuation analyst to project a business’s future cash flows, then calculate the present value of the sum of these cash flows by employing an appropriate discount rate. The valuation analyst must address risk in two primary areas: projected future cash flows and the discount rate. Effective ERM processes can help businesses increase value by affecting the estimates for these quantities.
How does risk impact projected cash flow?
There exists a risk that an organization will not achieve its projected figures. As such, the process by which management projects future cash flows can impact a valuation analyst’s assessment of the business. A key risk in the process is information integrity, the quality of information generated through monitoring and data assimilation.
Information integrity allows management to make well-informed decisions and should provide a valuation analyst with greater confidence in a business’s projections.
Valuation analysts can analyze information integrity by examining historical projections and assessing elements of the internal control environment.
A valuation analyst also should examine the variance between historical projections and a business’s actual performance. If a strong correlation exists, a valuation analyst can be highly confident in current projections, if the process employed by the organization remains constant. If not, the analyst must examine the variance between the past projections and actual performance to discern whether bias existed in past estimates and current projections.
What about risks in the discount rate?
The discount rate is the yield necessary to attract capital to a particular investment, given the risks associated with that investment. A project with relatively high risk will require a relatively high yield to compensate an investor for bearing these risks.
In determining the discount rate, there are two sources of risk that need to be quantified: systematic and unsystematic.
Systematic risk is the risk one must bear for taking on a risky investment in the market. However, systematic risk is estimated by calculating the return to public equities due to availability of data. The ERM process has little impact on systematic risks unless the business’s performance is heavily tied to market performance.
Unsystematic risk is sometimes broken down into two components, industry risk and company-specific risk. Industry risk reflects the risks identified with the industry in which a business operates. Company-specific risks encompass all other risks, including size, depth of management, geography of operations, customer and/or vendor concentration, competition and financial health.
How can ERM processes mitigate company-specific risks and increase value?
An ERM process should quickly gather and assimilate high-quality information for use in the organization’s decision-making process, allowing the organization to rapidly assess the impact and likelihood of risks associated with changes in its internal and external environments. Early assessment and mitigation can help preserve value and capitalize on risky events when competitors do not react as swiftly to environmental changes
John T. Alfonsi is managing director at Cendrowski Corporate Advisors. Reach him at (866) 717-1607 or firstname.lastname@example.org.
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Identifying the intrinsic value of your company is an extraordinarily beneficial exercise, especially when business owners are looking to maximize the sale of their company, says Joshua Geffon, a shareholder at Stradling Yocca Carlson & Rauth.
“The crown jewel of an enterprise may be intellectual property (IP), the management team, key customers or brand recognition, and/or any combination of these ingredients. The key for an entrepreneur is to recognize, exploit and promote these attributes to gain maximum value for the enterprise during the acquisition process,” Geffon says.
Smart Business spoke with Geffon about what business owners should know before engaging in the acquisition process.
What are some mistakes owners make that jeopardize the sale of their companies?
A fairly common mistake is not doing enough to secure the company’s IP. Confidentiality and IP assignment agreements, patent filings and related IP protection should be in place to have clear and strong IP ownership and title.
Broad indemnification by the seller on contracts creates risk that buyers of companies don’t like. Material contracts that allow customers, suppliers, service providers or other partners to easily terminate can significantly undermine a seller’s value proposition.
Also, tax and planning is critical. Overlooking tax-related filings often leads to significant turmoil and financial hardship. Inversely, proactive corporate and personal tax planning for founders and executives also can create real economic benefits.
What’s important to have in order before initiating the acquisition process?
Be sure you are prepared to provide copies of well-organized and complete corporate, capitalization and financial records, as well as material contracts, as part of a due diligence review by the buyer. Being well organized on these matters ahead of time will buy a lot of credibility with the buyer. Messy or inaccurate records will cast doubt on the value of your company.
What legal pitfalls often trip up the sale?
Buyers are always concerned about risk. Risk comes from inside your company in the form of personnel — employees, consultants and others — and outside from lawsuits, warranty and return claims, supplier terminations and limits on business operations.
Employees are often the company’s greatest asset and typically a company’s largest expense. Sellers usually engage in pre-emptive measures to entice employees to stay by offering equity, cash and other incentives that require personnel to work as diligently for the buyer as they did prior to the transaction.
Your company’s value proposition may be significantly weakened, and deals have died, if buyers identify agreements that limit rights to develop, manufacture, assemble, distribute, market or sell products.
How do you determine a realistic price?
Depending on the stage of your business and the industry, there are a few methodologies available. The most common are discounted cash flows and price to sales, but this relies upon a history of revenues and costs and/or sales. Early stage companies have a harder time utilizing these valuation methods.
When traditional valuation models are inapplicable, recent transactions in the sector or the valuation of similar public companies can be used. Gauging your value proposition with board members, advisers and strategic partners can help you solidify an approximate value.
Remember that buyers are valuing your business on your financial statements, projections, business plan and opportunities in your industry, along with synergistic opportunities with the buyer.
Who should help a business owner in a sale?
Secure competent, experienced service providers. These people will help you get a better sense of the market, your company’s value and your risk exposures. Get them involved well before the sale to ensure the process runs as efficiently as possible.
A good merger and acquisitions attorney will lead you through the process, identify and mitigate risks, and explore potential resolutions to issues ahead of the transaction. An independent accountant who can review and audit your financial statements also may be needed.
Joshua Geffon is a shareholder at Stradling Yocca Carlson & Rauth. Reach him at (424) 214-7000 or email@example.com.
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I was recently involved with a commercial lease transaction that yielded the greatest percentage savings and bottom line impact to a company that I have witnessed in my 28 years as a Certified Public Accountant.
This is saying a lot, as I have a background in corporate finance and auditing with Ernst & Young and Lockheed Martin Corp. I have been deeply involved with strategic, long-term business planning, corporate turnarounds and taking private companies public. My clients looked to me for expertise on increasing revenue, reducing costs and creating value. They also want quick results with minimal disruption to their business and customer relationships.
In addition to other duties, I review and provide financial analysis on commercial real estate transactions. As a CPA, I know that the most significant costs to a company in the general and administrative line items on the profit and loss statement are typically personnel and real estate expenses.
When developing a long-term strategy, what should analysts consider?
When assessing a business valuation or developing long-term strategy, it is commonplace for analysts to simply consider real estate and related expenditures as fixed costs as they relate to leases that are in place that cannot be changed. Moreover, they feel that the fair market system and competitive market forces will be the primary driver of these costs.
This brings us to my experience with the real estate transaction referenced above. The company in this case is a multinational corporation headquartered in Europe, with offices in the United States. It has a very sophisticated executive team and was in need of expanding operations to meet new business demands — which was nice to see given the depressed business climate over the last few years.
The company was not represented by a real estate broker because its landlord had convinced it it could negotiate better terms without one, as he would pass along the commission savings to it. That sounded plausible, so the company proceeded without representation and its CFO commenced negotiations.
The CFO was very capable, and after three months of negations, remained unsettled with regard to the progress he had made given the landlord’s best-and-final terms. Frustrated, he finally conceded to meet with real estate brokers that had been calling to represent the company’s interests. After interviewing several firms, the company hired Robert Chavez of Guardian Commercial Realty.
The company’s executives were impressed with Guardian’s market knowledge and cost-reduction strategies, and especially surprised that Guardian guaranteed results. The company also learned about ‘exclusive tenant brokerage’ for the first time from Guardian and understood that its interests would be protected by its broker — not the landlord’s interests.
This assignment was going to be particularly challenging in that the company had waited so long to consider other options that there were only a few months left before their existing lease expired. Its landlord was clearly using this as leverage and was convinced that the company would not, or could not, relocate in the time remaining.
How can a real estate broker reduce costs and risks?
Because I attended these meetings and completed the Financial Cost Comparisons, I can unequivocally attest that Guardian reduced the company’s occupancy costs by nearly 30 percent, or $1.3 million, as compared to the transaction it was about to sign. Guardian was able to condense months of due diligence and negotiations into a 34-day turnaround from start to finish. Guardian utilized third-party experts to complete space programs and efficiency studies, found a building with a floor plan that better suited the company’s unique layout (with far superior views), reduced the rental rate, and increased landlord concessions and construction allowances to achieve these incredible results. Guardian even negotiated short-term, temporary space at a highly reduced cost to avoid any holdover issues at the existing location.
I also noted that the $1.3 million savings dwarfed the amount of any commissions. It was clear that the existing landlord’s initial offer of passing along savings from commissions was nothing more than a ploy to keep its tenant from becoming informed and guided by an experienced real estate professional.
As a CPA, watching this company save so much money without paying any fees or having to employ drastic cost-cutting measures such as layoffs or scaling back operations was impressive, to say the least. From my perspective, if a company has a profit margin of 10 percent, it would have to increase sales by $13 million to achieve these results. Never in my career had I seen such astonishing and tangible results in such a short period of time.
To my amazement, Guardian’s work did not stop once the business points had been agreed to. It worked in conjunction with the company’s legal counsel and offered additional comments and strategies that were utilized to consummate the transaction.
The end result was a very satisfied client. By utilizing a real estate expert that focused on exclusively representing tenants, the company was able to relocate into a building with a more efficient and impressive floor plan while reducing costs and risk in the process.
As I see it, these results will continue to pay dividends to the company over the long-term lease. It is likely that office rents will escalate and the company will enjoy a competitive advantage over its competitors as a result of the hard work I witnessed firsthand. What can I say — numbers excite me — I’m a CPA.
I was so taken by the impact of this transaction that I have made a personal decision to learn more about the business of tenant brokerage and become actively involved in the process. I see now how traditional brokerage models have conflicting interests as they try to represent property owners and tenants.
For more information about Guardian Commercial Realty, contact Robert Chavez at (310) 882-2060 or Robert.Chavez@GuardianUSA.net.
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Knowing the value of your business is important for making wise gifting decisions, especially because there could be quite a difference between an organization’s perceived value and its actual value.
“Business owners really should know how much their business is worth so they can determine whether or not to make a gift, and to ensure the amount of the gift is appropriate for their estate plan,” says David Heilich, family wealth planning practice leader at Brown Smith Wallace LLC, St. Louis, Mo.
As a result of the recent recession, lower fair market values have made gifting a much more attractive option, giving business owners the opportunity to leverage closely held stock and partnership/LLC interests, especially when applicable discounts for lack of marketability and lack of control (the so-called minority shareholder discount) further decrease the amount potentially subject to taxes.
At the same time, doing a business valuation sooner rather than later — meaning years before a possible ownership change — can potentially add to the future value of the business when an eventual sale to an outside party is planned.
“Now is a great time to discuss with a professional how to take advantage of estate planning opportunities,” says Cathy Roper, director of financial advisory services, Brown Smith Wallace.
Smart Business spoke with Heilich and Roper about year-end gifting and the benefits of a business valuation.
What year-end gifting opportunities make this an attractive time of year to be generous?
Currently, there is a $5 million gift exemption, which is significantly higher than ever before, and, under the current law, in 2013, the estate, gift and generation-skipping tax (GST) exemptions decrease to $1 million, with the GST exemption indexed for inflation. In 2011 and 2012, single individuals with net worth of at least $5 million, and married couples with net worth of at least $10 million should consider making outright gifts and/or executing various estate planning techniques.
Advisers should take into account the nature of the assets being gifted and projected future values to determine if gifting makes sense and to avoid gifting too much.
How should an individual plan this year, considering the uncertainty of gift laws in 2013 and beyond?
It is unknown when the law in 2013 and future years will be settled, and if there will be any changes to the current law. You don’t want to be paralyzed by the uncertainty of the future. The opportunities in 2011 and 2012 could be lost if you wait until there is better guidance on the current and future estate and gift tax laws.
There are a lot of creative estate and gift tax planning opportunities that provide options and flexibility. Consult with a team of qualified professionals and take into account all relevant factors in order to make an educated decision about whether now is the time to take advantage of gifting opportunities.
How can getting a business valuation years before an ownership change is planned potentially add to the future value of a business?
A business valuation is an opportunity to do a ‘wellness’ check of your business and provides you with the type of dispassionate view a potential buyer will have. The valuation analyst will tell you where your company ranks compared to the industry on a number of different measures such as days outstanding on receivables, capital expenditures as a percentage of sales, gross profit margins, etc., and suggest areas where efficiency and, thus, profitability, can be increased.
Here’s an example: In a recent due diligence engagement in which we were evaluating a software business for a potential investor, we recommended switching from a traditional development model in which a client purchases the software and upgrades as new versions come out to a software-as-a-service model in which the software is leased and the continuous monthly lease payments smooth out the revenue stream and cash flow. This reduces the need for interim financing, reduces income variability and stabilizes the customer base, which reduces risk for a potential buyer. The less risk an investor has, the safer the investment is and the more an investor is willing to pay, or, put another way, predictable cash flow is always more valuable.
What is involved in the process of getting a business valuation?
The process is fairly straightforward, but often takes four to six weeks. First, you will receive a document request list that requires gathering at least five years’ worth of financials on an accrual basis, along with the most current financials. These are reviewed, and your ratios are compared to the industry average.
Once the valuation analyst gets a feel for the industry’s outlook and how the company compares to the industry, he or she will schedule an on-site visit in which owners are interviewed and questions are asked to further assess the company relative to the industry and to its competitors. Documents reviewed may include corporate charters, partnership agreements, minutes and any previous offers to buy the company.
Is it too late to begin the gift planning and valuation processes after the New Year?
Not at all. 2011 is an opportune time to take advantage of gifting opportunities, and a valuation is important to make wise decisions. Under current law, the gift exemption continues through 2012, so the New Year will still provide opportunities to continue estate planning and reap benefits from current estate, gift and GST exemptions.
David Heilich is family wealth planning practice leader at Brown Smith Wallace. Reach him at (314) 983-1273 or dheilich@ bswllc.com. Cathy Roper is director, financial advisory services at Brown Smith Wallace. Reach her at (314) 983-1283 or firstname.lastname@example.org.