How the sale value of a business is properly determined

The value of a business is commonly a large portion of its owner’s net worth. Understanding what the business is really worth, or could be worth, allows an owner to make important decisions regarding key issues like retirement, estate planning and choosing a business successor.

A frequent question owners ask is, “What is my business worth?” The answer is not necessarily what the assets would sell for — a common misunderstanding of owners.

Smart Business spoke with James F. Schultz, principal at Cendrowski Corporate Advisors LLC, about how the sale value of a business is properly determined.

Learning what your organization is really worth can bring dividends

The first step is to hire an independent valuator to determine the realistic sales price of the business. This important step should be done by a professional experienced in merger and acquisition processes and in valuation analyses. The valuator will look at the business and use the standard valuation approaches of asset, income and market to estimate the enterprise value of the business.

For most operating businesses, the income and/or market approach will have the most influence in estimating the sale value of the business. Research is needed into the industry of the business to find trends and key economic factors driving profitability.

Next, a look at sales of comparable businesses in the industry can provide various multipliers of income factors that can be applied to the business. If comparable sales are not available, estimating proper investment returns on income based on risk/reward analysis will estimate value.

When applying the income approach, it may be necessary to identify synergies/cost savings created from the sale. This will enable the valuator to establish investment value (to an acquirer) rather than fair market value (to a hypothetical purchaser).

In cases where the return on investment is low and/or little labor is involved, the asset method may be more applicable.

What happens after the enterprise value is estimated?

The next step is to estimate what the purchaser will actually receive from the seller. Most sale transactions today are structured as asset sales rather than stock sales. In an asset sale transaction, specifically identified assets and liabilities of the selling company will be transferred to the purchaser. The purchaser will require all the fixed assets necessary to run the business, which can range from computer systems to manufacturing machinery.

In addition to the fixed assets, the purchaser acquires various intangible assets and rights relative to trade names, patents, goodwill, occupancy/lease rights, client lists and vendor lists, to name a few. The more difficult item to quantify is the level of working capital that the purchaser will require as part of the sale transaction.

The purchaser is looking to acquire an operating business and the necessary liquidity to allow the business to continue to operate in a smooth fashion without requiring additional equity amounts.

The items typically included in working capital are accounts receivable, inventory and accounts payable. The net value of those amounts need to provide a liquid cushion to continue business operations. The sale negotiations will normally determine the appropriate level of liquidity, and an adjustment of the purchase price may be required if the level is not met or if there is an excess when the sale closes.

In most cases, the purchaser will not assume liabilities other than trade payables.

After estimating the purchaser’s requirements, what are the final steps?

The final step is to analyze the existing balance sheet of the company for items that will not be transferred to the purchaser. This typically consists of cash, investments and other non-operating assets on the asset side, and all liabilities excluding trade accounts payable on the liability side. The net value from the combination of the aforesaid items is then added to/subtracted from the enterprise value. The result of that computation is the estimated net sale proceeds of the business.

In order to determine what the owner will be able to put in the bank, an estimate of the income taxes related to the sale transaction should be calculated. That amount is subtracted from the estimated sale proceeds to determine the after-tax cash available to the owner.

Insights Accounting is brought to you by Cendrowski Corporate Advisors LLC

 

How to proactively manage risk to identify and navigate strategic pitfalls

Companies need to understand all of the perils that could impede the success of their business objectives. The problem is that risk management is often reactive in nature. It occurs at a process or transactional level, aimed at remediating a problem. For example, shipments of goods are frequently delayed; so then management examines the processes to determine how to make sure it doesn’t happen again.

“It’s reactionary. It’s targeted. It’s very narrowly focused on the pain point at that point in time, and at that moment — the squeaky wheel gets the oil,” says Laurence Talley, CPA, CIA, senior director of Risk Advisory Services at BDO USA LLP. “I think all organizations are guilty, to one extent or another, of operating like this.”

When organizations are assessing risk they may consider financial, operational and compliance risk, but the one that gets ignored is strategic risk, Talley says.

Smart Business spoke with Talley about using risk management to not only protect but also enable your strategic goals.

Where do you see organizations misstep when it comes to strategic risk?

A company’s strategic goals are well developed — supported by data, tested in the market and communicated to boards, advisers and even customers. What’s lacking can be a supplement to the strategic plan or objective that prompts an organization to pause and consider what could go wrong, and its tolerance for those risks.

Employers need to ask: ‘What things have historically been barriers to us satisfying similar goals? What processes and controls can help us successfully navigate through this potential risk, either from a preventative or detective standpoint?’

You want to build an entitywide, top-down approach to thinking about and identifying risk, and then respond to those risks in an uniformed, forward-thinking way. This is how risk management can be used to help satisfy and meet strategic objectives, versus just simply protecting and preventing the occurrence of perils as you do business.

If you have a headache you can take aspirin, but it’s better to drink water and get enough sleep to avoid a headache in the first place. Be preventative — focus on the entire health of your organization, entitywide, not just the current problem or pain point.

What’s an example of strategic risk?

A common strategic initiative is that your organization wants to grow by acquiring a smaller competitor. Some associated risks are that your pursuit strategy is leaked, or your purchasing approach isn’t well received. So, put some forethought into these pitfalls, developing a risk strategy to mitigate them before they occur.

Should companies be formal with this planning? Can it be an informal discussion?

There are merits to both. Informal discussions allow for expediency but you forfeit accountability and consistency. If you formalize it, however, you can socialize it throughout your organization in a systemic and consistent manner. If your executive team talks about the risks and what you’ll do when you face them, there’s a benefit to that. But perils present themselves at all levels. You need to make sure all of your people, from executives to staff, have a similar understanding. It’s often the employees in the field, serving clients and making your products who can identify the most impactful risk and take steps to mitigate it.

What are other best practices for proactive risk management?

Think about strategic risk from the standpoint of people, processes and technology. Have the right people participate in the risk strategy activities — from executives on down — to get a diverse set of thoughts on how you manage risk. Make risk strategy activities an ongoing process with evaluations, in order to stay a step ahead. And don’t be afraid to leverage tools and data.

For example, many consumer product companies use analytics to predict what’s trending in order to develop cutting-edge products; therefore, flip that premise and use technology with different data points to predict and understand what perils may be likely.

Today, people have a better understanding of the value of risk management. But when you can use it to help protect your company, enable the success of strategic initiatives and accomplishment of goals, that’s when the real buy-in occurs.

Insights Accounting & Consulting is brought to you by BDO USA LLP