Business Valuation Blog

If you asked my Grandpa what the rate of return on his investments is, he would probably scratch his head and say, “Huh?” The only return that he knows (even though he doesn’t necessarily understand it) is the .5% that he earns on his savings account with the local bank. If you asked my Dad the same question, he might say that he earns a few percentage points per year. His investments are being allocated in a more conservative fashion as he nears retirement. In my case, most of my retirement investments are in equities. My investments have much greater risks than my Dad and Grandpa’s, but they also present opportunities for much greater returns.

Out of my family’s three generations of investments, the “safe” savings account investment of my Grandpa (which could be debated in light of the wave of bank failures over the past year), has the lowest levels of both risk and return. My Dad’s investments have a higher level of risk, but a correspondingly higher rate of return. Finally, my investments have the highest rate of return out of the group, but also the most risk that the return will not be realized (leaving me with less money than I invested).

The concept of risk vs. return is important in the valuation of any business. The lower the risk associated with an investment, the lower the required returns. In contrast, the riskier that an investment is, the higher the return it should provide to an investor. The value of an ownership interest in a company typically moves opposite of the level of risk and required return, as summarized below:

High Risk = High Required Returns = Lower Company Value

Low Risk = Low Required Returns = Higher Company Value

One of the abilities that a valuation analyst brings to the table is his or her ability to determine an appropriate rate of return for an investment in a company. As discussed above, once the rate of return is determined (as a function of the level of risk), it plays a key role in concluding on the value of a business. Keeping in mind the general relationship between risk and return can help anyone better understand the value of a business, regardless of their level of valuation experience. 

Looking for business valuation assistance in Cleveland or Akron? Contract our Business Valuation Group at 440-449-6800 for more information.

There are many tales behind the origin of the phrase “rule of thumb”, some of which are more realistic than others. The story that is the most widely accepted is that woodworkers used to use the width of their thumb, rather than rulers, for quick measurements.  Regardless of how the phrase got its start, a rule of thumb is considered to be an imprecise, yet convenient measurement standard. Relying solely on a rule of thumb to value a business, however, can lead to unreliable valuation conclusions.

Rules of thumb used for valuing businesses are often industry specific and are stated as multiples of revenues, EBITDA, net income, or some other metric. Rules of thumb often have their foundation in industry hearsay mixed with multiples derived from actual transactions for similar companies (although which transactions and companies are anybody’s guess). Considering the unprecedented economic environment today, older rules of thumb may no longer be reliable regardless of their predictive power of value in previous years. In addition, rules of thumb often do not take into consideration the profitability of the company being valued, the industry outlook, the depth of management, and many other factors that are considered when a full business valuation is being prepared. Finally, nearly every professional valuation association (if not all of them), does not allow for a rule of thumb to be used as the primary valuation methodology. As a result, relying on a rule of thumb alone to value a business will result in a value that will not be defensible before the IRS or in litigious situations.

Although using a rule of thumb is frowned upon as a primary valuation method, rules of thumb may still be beneficial to business owners and valuation analysts.  For business owners, rules of thumb offer quick and dirty estimates of value that can be useful for high-level strategic planning.  For valuation analysts, rules of thumb can be used a reasonableness check for the value of a company determined by asset, income, and market-based approaches.

The important thing to remember is that a rule of thumb is a great shortcut for a business owner to use to determine the value of his or her company for strategic planning. If a defensible value is required, however, a rule of thumb should be used as no more than a cross-check against the more traditional valuation methods, such as the capitalization of earnings/cash flow method, discounted earnings/cash flow method or private company transaction method.

Looking for business valuation assistance in Cleveland or Akron? Contract our Business Valuation Group at 440-449-6800 for more information.

When you think of a crystal ball, what types of people come to mind? Prophets? Magicians? Shady fortune tellers? While all of these people are associated with the act of attempting to predict the future using a crystal ball, there is another group of people who still today rely on their figurative crystal balls whether they know it or not: business owners.

Every day, business owners must make estimates and guesses about the future of their companies with the intent to position themselves to take advantage of whatever opportunities may arise. Whether through preparing budgets for next year or creating 5 year projections for use in business planning, business owners often need to gaze into their crystal balls and attempt to predict the future.

Getting business owners to dust off their crystal balls is essential during the business valuation process. Owners or management are often hesitant to provide projections or estimates to business valuation analysts, sometimes under the notion that if the analyst has access to the company’s historical financial statements, they have all that they need to properly determine the company’s value. While historical financial statement analysis is a key component of any reliable business valuation, it is the future operating expectations of a company that truly drive its value.

Imagine being presented with the option to invest in either of two companies for the same price. Company A generated $10 million in annual cash flow up to the valuation date, but due to changes in the industry, is only expected to generate $1 million in annual cash flow going forward. Company B only generated $1 million in annual cash flow up the valuation date, but is expected to generate $10 million in annual cash flow going forward due to the development and release of a new product. Which company would you rather invest in? Obviously, considering the limited facts presented, the rational investor would choose to invest in Company B due to its superior operating expectations compared to Company A.

Value is driven by future operating expectations, not historical results. Only in cases in which management’s expectations are that future results will mirror the company’s historical operations can historical results reasonably be relied upon to determine a company’s value. Historical results can also be relied upon to determine the reliability of a company’s projections.

Therefore, if a business owner is in need of a business valuation, it is important that he or she dust off their crystal ball and spend some time thinking about the operating expectations for their company. While none of us can predict the future with any certainty, obtaining some sort of expectation for a company’s future operating results is essential to the development of any properly performed business valuation.

Looking for business valuation assistance in Cleveland or Akron? Contract our Business Valuation Group at 440-449-6800 for more information.

As a kid, baseball and football trading cards were my life. I would absorb the stats on the back of each card and rattle them off at school like it was a homework assignment. I have boxes and boxes of cards that I accumulated over the years, as I am sure that may of you do (if your mom hasn’t tried to throw them away yet). What do baseball cards have to do with the value of your business? More than you think.

Magazines such as Tuff Stuff and Beckett quote estimated prices for nearly every sports trading card available. These prices are representative of what we in the valuation world would call “fair market value”. This is the price at which a willing buyer and a willing seller, with all material facts about the card known to them, would likely transact. A majority of business valuation engagements, including those for IRS gift and estate tax reporting purposes, divorce proceedings, and as directed by many operating agreements, require fair market value to be used as the standard of value. Fair market value typically contemplates that the purchaser is a “financial” buyer (someone who is making an investment in the business with no means to create synergies or other economies of scale), unless certain circumstances dictate otherwise.

When many business owners contemplate the value of their business, however, they often think of a larger company similar to their own paying a premium for their business. The assumption made by the business owner is that the purchaser will be able to recognize certain post-transaction efficiencies, which will allow the acquirer to pay more for the business than a “financial” buyer. This is called “strategic value” or “investment value” (the value to a specific buyer), which is not the standard of value required to be adhered to in many business valuation engagements.

For example, I have a 1994 Kenny Lofton Upper Deck card that has a quoted value of $.10 according to Beckett. Someone who has the entire 1994 Upper Deck set except for the Kenny Lofton card that I own may be willing to pay a premium above the card’s $.10 “fair market value” because that owner can derive additional value by completing their set. This premium price is the “strategic value” or “investment value” to that specific owner, but is not reflective of the card’s “fair market value” in the general marketplace. 

While a business’ underlying assets are the drivers its value, the perspective from which that value is determined can have a significant impact on the final number. When business owners are in need of valuation services, it is important that all of the parties understand what standard of value is being used, whether it is “fair market value” or something different, so that the value of the business is considered in the correct context. 

Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Group at 440-449-6800 for more information.

Due to the unprecedented economic conditions of the past year and a half, many companies had to take a challenging look at whether their goodwill was impaired during their last audit or review. For those companies that did not record any impairment of goodwill in 2008, continued economic pressures in 2009 may make avoiding impairment two years in a row a difficult proposition. 

In the whirlwind of goodwill impairment discussions, however, impairment testing for other intangible assets seems to have been thrown on the back burner. When the accounting for many business combinations is executed, intangible assets are also often recorded (customer lists, non-compete agreements, trademarks, etc.), sometimes in excess of the recorded goodwill. Therefore, testing intangible assets other than goodwill for impairment can be just as, if not more, important than testing goodwill for impairment depending on a company’s asset composition.

Part of the reason for the reduced focus on intangible asset impairment testing may be the fact that intangible assets with finite lives are only considered to be impaired if the undiscounted future cash flows associated with these assets are lower than their net carrying values. This is the same “high hurdle” rule that governs whether fixed assets are impaired. As a result, the cash flows associated with an intangible asset typically need to have deteriorated significantly in order for an impairment to be recognized. Keep in mind that indefinite-lived intangibles do not have the same “high hurdle”, undiscounted cash flow test. Rather, the fair value of indefinite-lived intangibles must be determined each year, similar to goodwill, and the intangible would be written down to its fair value if it is determined to be less than its current net carrying value.

The materiality of the assets along with the risk appetite of a company’s auditors will determine the required extent of testing for the impairment of intangible assets. It should be noted that a company’s auditors are not permitted to prepare the intangible asset testing, which would result in the auditors auditing their own work. Rather, the company’s management or a third-party firm must prepare the analysis, which the auditor can then audit. 

Business owners and operators need to keep in mind that increased emphasis will be placed on the testing of intangible assets, including goodwill, during the 2009 year-end audit season. The testing of intangible assets for impairment is something that should be discussed with your auditors sooner rather than later so that a plan of attack can be developed that will address the issue to your auditor’s satisfaction and save any ugly surprises from popping up late in an engagement related to impairment concerns.

Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Group at 440-449-6800 for more information.

Many of us probably remember Harvey Dent, aka “Two-Face,” from our childhoods as one of Batman’s arch enemies. He looked like a normal guy from one perspective, but from the other side, he was a bizarre-looking villain. While normalizing adjustments in business valuation may not be quite as exciting as watching Batman battle Two-Face, they bear a similarity to this comic book character.

The results of many companies as reported in financial statements or tax returns do not always reflect economic reality. Therefore, normalizing adjustments are required when business valuations are performed to present a company’s income statements and balance sheets at their true economic levels, without distortion from accounting rules or the owners’ operational preferences. A company’s value can look completely different after normalizing adjustments have been made – it is almost like spinning Two-Face around to look at one side as opposed to the other. 

For example, an owner may be taking a very large salary in an effort to reduce taxable income and income taxes, effectively eliminating any net income. When employing an earnings-based approach in valuing such a company, a normalizing adjustment would likely be necessary to adjust owner’s compensation downward to an appropriate fair market value, effectively raising net income and the resultant value of the company. 

It is important to note that normalizing adjustments can both increase, or decrease, net income. Another common normalizing adjustment occurs when a related party rents property to the company being valued at a monthly cost lower than the property’s fair market rental value. In this case, the valuation expert would increase the company’s rent expense to fair market value, effectively reducing net income and lowering the company’s value. 

While valuation experts are trained to identify normalizing adjustments through trend analysis and management inquiry, business owners and advisors can make the valuation process run more smoothly by bringing potential adjustments to the attention of their valuation expert. It is ultimately up to the valuation expert’s judgment as to what normalizing adjustments are appropriate for a given company, but when a business owner is prepared to answer questions regarding potential adjustments, it can lead to a more efficient valuation engagement.

Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Group at 440-449-6800 for more information.

While the likely adoption International Financial Reporting Standards (IFRS) is a hot topic for accountants, many privately-held small and medium-sized business owners may not be aware of the potential changes on the horizon for financial reporting. The general consensus is that in the coming years, the U.S. will move to adopt IFRS in place of Generally Accepted Accounting Principles (GAAP) as the governing standards for financial reporting, although no official date for conversion has been set yet. 

As discussed in the September 2009 issues of the Journal of Accountancy, IFRS for Small and Medium-Sized Entities (SME’s) was released in July 2009 after five years of development. SMEs are defined as businesses that publish general-purpose financial statements for external users and do not have public accountability. IFRS for SMEs is much more condensed than the full version of IFRS and does not address many of the areas that do not apply for privately-held companies, such as segment reporting or earnings per share.

What does this new standard mean for small to medium-sized business owners and operators? 

Some of the most significant differences between IFRS for SME’s and U.S. GAAP are:

-          Simplified disclosures for pensions, leases, financial instruments, and other areas.

-          Prohibition of the last-in, first-out (LIFO) method of inventory valuation.

-          Amortization of goodwill and indefinite-lived intangibles over a period of ten years or less.

-          Simplification of the temporary difference approach to income tax accounting.

-          Greater use of historical cost in accounting for financial assets and liabilities.

While the actual transition from U.S. GAAP to IFRS has yet to occur, privately-held small and medium-sized business owners should know that the next set of financial reporting standards that they may have to follow have been tailored to fit their needs and the needs of the users of their financial statements.

Looking for Cleveland or Akron CPAs, business or financial advisors? Contact Skoda Minotti at 440-449-6800.

What did Picasso’s paintings look like when he was only halfway finished? How did Michelangelo’s “David” look like after the first few chisels? How livable is a house after the frame has been erected, but no interior work has been done?

A valid answer to all of the preceding questions is, “Something different than the final product.” However, for financial experts who provide opinions on economic damages and other litigated matters involving calculated figures, current rules sometimes allow for previous non-submitted, and non-final, drafts of an expert’s report to be considered discoverable evidence. 

The review of draft iterations of an expert report is often considered to be a waste of time (and dollars) as such drafts often do not correctly capture all of the relevant information that was synthesized in the final submitted report. Oftentimes, the tactic of reviewing an expert’s draft reports is an attempt by an opposing attorney to discredit the expert or make the expert’s conduct appear improper in some way. Therefore, some attorneys will request that non-final draft iterations of reports be admitted as evidence and scrutinized, distracting the court from the analysis offered in the financial expert’s final, submitted opinion. 

This is akin to asking Phil Collins to stop all work on a song that he is still feeling his way through, releasing that song, and then asking him to defend its quality to the public and his fans. Not only is this unfair to Phil, but it is unfair to the music-listening public, who expect a polished, quality product that Phil would be willing to stand by. 

In a recent article by Thomas Hilton, MS, CPA/ABV/CFF, ASA, CVA in Financial Valuation and Litigation Expert, a highly-regarded publication in the business valuation and litigation support field, Mr. Hilton discussed that relief for this problem may be on the way. The Committee on Rules of Practice of the Judicial Conference of the United States (Committee) recently proposed amendments to the Federal Rules of Civil Procedure that would shield draft expert reports from discovery. If the proposal makes its way through the necessary channels without any holdups, this relief could come as soon as December 1, 2010. 

As part of the community of financial experts, we hope that relief from the proposals highlighted above (which have been backed by the AICPA) comes swiftly. Primarily, we believe that these proposals will force courts to focus on the merits of an expert’s submitted opinions rather than the potentially unfinished and in-process analysis that is present in draft reports.

Need assistance with a litigation matter? Contact our Litigation Advisory Services Group at 440-449-6800.

Topics: Litigation Advisory Services, Cleveland Business Advisors, Akron Business Advisors, Akron Business Consultants

We, as consumers, love discounts. There are few things more satisfying for a savvy shopper than finding a deal on an item that he or she has been longing for. When it comes to valuing a business, some believe that “discount” is a dirty word and that it implies that the seller is not receiving fair market value for his ownership interest and that the buyer is getting a deal. This is not the case, however, as valuation discounts merely adjust the value of an ownership interest indicated by certain valuation methods for specific characteristics that need to be addressed before arriving at fair market value. 

The most common discounts seen in valuation reports are for lack of control and lack of marketability. 

Lack of Control Discounts

Lack of control discounts are appropriate for ownership interests in which the owner cannot unilaterally direct the company’s operation. A lack of control discount is applied because a non-controlling owner cannot appoint management, set levels of management compensation, declare dividends or distributions, compel a liquidation of his or her ownership interest, set company policies, or purchase or sell assets, just to name a few things. These factors make a non-controlling interest less valuable than a controlling interest.

Marketability Discounts

Marketability discounts are also often appropriate in the valuation of privately-held businesses.  There are certain marketability differences between an interest in a privately-held business and an interest in the stock of a publicly-traded company. An owner of publicly-traded securities can know at all times the market value of his or her holding based on the quoted price per share. He or she can sell that holding on virtually a moment’s notice and receive cash, net of brokerage fees, within several working days.

This is not the case with ownership interests in privately-held companies, however. Liquidating or selling a position in a privately-held company is a more costly, uncertain, and time-consuming process than selling the stock of a publicly-traded company. An investment in which the owner can achieve liquidity in a timely fashion is worth more than an investment in which the owner cannot liquidate the investment quickly. Therefore, an ownership interest in a privately-held company with the exact same characteristics as a publicly-traded company would sell at a discount compared to the publicly-traded company.

What Does It All Mean?

Valuation discounts are not a simple matter, but they are an essential part of determining the fair market value of ownership interests in privately-held companies. The subjectivity in determining valuation discounts is often a source of contention in valuations for divorce, shareholder disputes, and estate and gift tax filings. Therefore, it is essential that your business valuation analyst have a well-reasoned and thorough discount analysis in order to stand up to challenge or scrutiny. 

Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Group at 440-449-6800 for more information.

Topics: Cleveland Business Valuation, Akron Business Valuation, Certified Valuation Analyst

A business valuation is a just a business valuation – isn’t it? This would be akin to saying that a steak is just a steak when, in fact, there are ribeyes, strips, sirloins, and filets (just to name a few). Likewise, business valuations come in two distinct “flavors” – conclusions of value and calculations of value.

As of January 1, 2008, valuation analysts who hold either the Certified Valuation Analyst (CVA) credential supported by the National Association of Certified Valuation Analysts or the Accredited in Business Valuation (ABV) credential supported by the American Institute of Certified Public Accountants have been required to follow new standards that clearly delineate between two types of valuation engagements. Similar to the differing levels of service traditionally offered by accounting firms in performing audits, reviews, or compilations, business valuation engagements are now separated into two defined service categories:

Conclusion of Value

-          All three valuation methods (asset-based, income-based, and market-based) are required to be considered

-          Detailed development and reporting requirements must be adhered to by the valuation analyst, making the engagement more time consuming than a calculation of value

-          This is the required type of report for estate and gift tax filings; Also typically required for instances in which the valuation analyst will need to defend his or her findings and report (i.e. in litigation)

-          The valuation analyst opines on the value of the business or business ownership interest

Calculation of Value

-          The valuation methods to be used in determining value are discussed and agreed upon beforehand between the client and the valuation analyst

-          Reduced development and reporting requirements compared to conclusion of value engagement

-          Ideal for planning purposes (e.g. strategic planning, transaction (purchase or sale) planning, or litigation or divorce proceedings in the settlement stage)

-          Valuation analyst does not opine of the value of the business or business interest, rather, the valuation analyst applies the valuation methodologies agreed upon with the client

-          Generally not defensible in litigation settings because the valuation analyst is not offering an opinion of value, rather, the analyst “calculates” a value based on methods agreed upon with the client

-          Typically costs less than a conclusion of value

-          Has been found to be useful in divorce situations in which a spouse will obtain a calculation of value to aid in the settlement process; If a settlement is not reached, the engagement can then escalate to a conclusion of value so that the valuation analyst can opine on a value and defend it in court, if needed

As you can tell from the discussion above, all “valuation” work is not created equal. For business owners, as well as their attorneys and other advisors, it is important to be aware of the varying levels of valuation service offered so that the appropriate type of report is obtained. You should discuss the purpose of the valuation with the valuation expert in detail as the engagement is forming so that the level of service can be tailored to your specific needs. 

The last thing that you want to do when having a valuation performed is pay too much to obtain a conclusion of value that will only be used for planning purposes or pay too little to obtain calculation of value that will not hold up in litigation or under IRS scrutiny.

Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Group at 440-449-6800 for more information.

Topics: Cleveland Business Valuation, Akron Business Valuation

If you had the choice of investing in two companies, both of which will earn $100 per year, but one company must pay $40 in taxes while the other pays nothing, which would you choose? The answer is easy - the company that does not have to pay taxes. But what if I told you that you would have to pay $40 in taxes personally on the earnings of the company that did not have to pay any taxes? 

The answer is not as clear cut once we introduce this nuance to the story because it would appear as if both companies are equally valuable. This simple illustration highlights one of the most controversial issues in both the business valuation community and the Tax Courts in recent years - whether it is appropriate to “tax-affect” the earnings of pass-through entities such as S-corporations, limited liability corporations, and partnerships, when determining their value. 

One school of thought on the subject is that because pass-through entities do not pay tax at the entity level, tax-affecting the earnings of such businesses (deducting an estimated amount of income tax from the entity’s earnings based on pre-tax income) is inappropriate. As a result, the value of a pass-through entity will be much higher than if income taxes had been deducted in determining its value. This approach gained popularity as five memorandum decisions issued by the Federal Tax Court from 1999-2006 denied a deduction for income taxes in determining the value of various S-corporations for gift and estate tax purposes. 

On the other hand, a more recent decision from the Delaware Chancery Court allowed a deduction for income taxes in the valuation of a pass-through entity. The Court’s reasoning was based on the theory that although income taxes are avoided at the business level for pass-through entities, the owners are ultimately responsible to pay income taxes on their share of the entity’s earnings that “pass-through” to them. Valuation analysts who subscribe to this theory argue that although income taxes are not paid at the entity level, there are still income taxes that must be paid on the earnings of pass-through entities – they are just paid at the shareholder/member level. When this theory is applied in the valuation of a pass-through entity, the resultant value is often times significantly lower than if the business’s earnings had not been tax-affected.

What does this mean for the owners and members of S-corporations, limited liability corporations, and partnerships? It means that when you are having your business valued, especially for estate or gift tax purposes, it is imperative that you gain an understanding of how the business valuation analyst intends to handle the controversial issue of tax-affecting pass-through entity earnings. Not only can the treatment of income taxes for pass-through entities have a significant impact on the concluded value of your business, it can also play a role in the likelihood of that value being challenged by the IRS. Therefore, it is crucial that your valuation analyst have a thorough understanding of the many complexities of this controversial issue, as well as a strategy for addressing them, or you could end up with a value that may not only be incorrect and unsupportable, but also result in the under-calculation (or over-calculation!) of your liability for estate tax, gift tax, or divorce purposes.

Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Group at 440-449-6800 for more information.

Topics: Cleveland Business Valuation, Akron Business Valuation