Save Money By Spending Money- Get The Price of Your Target Business Verified!

August 2, 2011

Quick show of hands- how many people will immediately take the word of a person who they do not know well that an item that the person is selling is worth what s/he says that it is?

For those of you who raised your hands, you can own a great valuation firm today for the very reasonable sum of… oh…. $16 million.

And I’ll even finance the deal for you, no interest involved- how’s $800,000 a year for the next 20 years sound?

Is the business worth what the person on the other side of the table says that it is?

For the 99.9% of you with your hands still by your sides, you know that it is probably a good idea to have the price of whatever asset you’re contemplating purchasing independently verified, by whatever means appropriate. If it’s a relatively minor purchase, you might have the price verified through a quick on-line search; for a more complex asset, you probably want to go to greater lengths to have that price verified.

If the asset that you are purchasing is a business, you are doing yourself a huge disservice if you take the word of the person selling the business that the business is worth what they say it is.

I was recently approached by an entrepreneur who had the opportunity to purchase a small business. The price that was quoted to her was $150k, and she did the right thing by asking me to independently verify that price. Turns out that the business was worth closer to $74,000- A FAR CRY from the original asking price. Smart business move on my client’s part- the cost of a valuation engagement saved her over $75,000.

How does this happen, anyway? Two main reasons:

  • The business owner who started his/her own business has so much blood, sweat, and tears invested into it, that the “halo effect” kicks in, and the business takes on way more value in the eyes of the business owner than an objective appraiser might impute.You might call it the “ugly baby” syndrome- no-one’s baby is ugly in their own eyes, and no business owner thinks that their business is not worth a lot of money.
  • There is obviously a legitimate reason why the seller of a business would like for it to be valued higher than it is truly worth- that person gets more money than they should after the transaction is complete. So information that might bring down the value of a business might be implicitly (or explicitly) de-emphasized, and information that might raise the value might be heavily emphasized. You might argue that that’s a normal human reaction; I would argue that this puts the business owner in a biased position, where they are not able to see the business in an objective light.

So the moral of the story is simple- even if the seller of a business is not being dishonest, there are always built-in factors that prevent him/her from being able to be objective about the value of the business. So if you are in the market for a business and have one in your sights, do the smart thing and have an independent entity “kick the tires” for you; you might save yourself $76,000 (or $16 million).

Next week, we will look at the fallacy of using common “multiples” to value a target business.

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Buy-Sell Clause- It’s Important, Folks…

June 24, 2011

If you are a partner in a business entity, it cannot be overstated that a buy-sell clause is MANDATORY.

Being in business with a partner, in many ways, is like being in a marriage. In fact, some experts who I know refer to business partnerships as “business marriages”. However, one major difference between the two types of marriages is the documentation that you might put before your partner.

If you were to offer a prenuptial agreement to a prospective spouse, you might elicit several reactions, most of them negative. But in a business partnership, a document that absolutely HAS to be in place before the partnership is official is the partnership agreement. Furthermore, an essential part of that agreement is a buy-sell clause.

So… what is a buy-sell clause anyway?

A VERY loose definition (**please see a business attorney for a more comprehensive definition that applies specifically to you) is that it’s simply a clause in your partnership agreement that addresses the conditions under which the business, or your portion of it (or your partner’s), would be sold. It also addresses the conditions under which the business would be valued, what assumptions would apply, and the “triggering events” that would cause the agreement to come into play.

Is this important? ABSOLUTELY. Consider, for example, two scenarios- identical businesses with identical financials; in one, the business owner does not have a partnership agreement, or at least not one that has a buy-sell clause; in the other, s/he does. Assume also, in a very simplistic manner for purposes of illustration, that the business is worth $1,000,000 at fair market value, based on a valuation of the company as a going concern; also, the ownership share split is 51%/49%, with the majority owner buying out the minority owner.

In the case where a buy-sell agreement does not exist, the typical resolution to this situation is a direct buy-out of the partner; doing the math (again, in a very simplistic, non-real-world example), the minority owner’s share of the business would be worth $490,000.

However, in the case where there is a buy-sell clause, the partners would have to adhere to the methods of valuation stipulated by the buy-sell clause. So, as an example, if the buy-sell clause stipulated that the value of the company, for purposes of buying the shares of the outgoing partner, is determined by the net assets of the business, and a current balance sheet shows a net asset value of $200,000, we are now talking about a value of the shares of the outgoing partner of $98,000.

So, assuming that you are the majority partner, and you are buying back 49% of the shares of your soon-to-be ex-partner, would you prefer to write a check for $490,000, or for $98,000?

Again- this is a really simplistic example, and there are several more moving parts in a real-world situation. But understand the larger point- being able to state the terms and conditions under which your company should be valued, and what situations would trigger the implementation of those conditions, can be the difference between you being in a really difficult situation if a partner has to leave, or you happily writing a check to get rid of a difficult partner.

Final word: if you do not have a good business attorney- please get one. YESTERDAY.


Partnership Agreement- GET ONE!!

May 10, 2011

My apologies for yelling the last two words of the title, but this is an important enough issue for me to raise my voice.

Let me be very clear about this; if you are in a business partnership, and do not have a formal, written agreement, GET ONE YESTERDAY.

I was contacted a few weeks ago by a very stressed out partner of a business. He/she was one of two friends who went to school together, were entrepreneurial in nature, and both contributed to getting a business off the ground some time ago. While initially all was well with the business operation, the person who contacted me (let’s call him/her Mr. Smith) was concerned that in the last few years, work was not being distributed equally in the business.

Mr. Smith also mentioned the fact that a major life-changing event was about to occur in the life of the other business partner (let’s call him/her Mr. Jones), and Mr. Smith was sure that Mr. Jones would not even want to be part of the business after the life event took place. Mr. Smith therefore wanted to know what it would take to buy Mr. Jones out of the business.

My first question to Mr. Smith was simply this: “What does the partnership agreement say about buyouts?” Mr. Smith’s answer was simple, yet ominous- there was/is no partnership agreement. The “implied” relationship is a 50% ownership by each partner.

My next question to Mr. Smith was, “In the absence of a formal agreement that addresses this type of situation, and with each of you owning a 50% share of the business, what gives you the right to buy out Mr. Jones?” Mr. Smith was adamant that, with the relative amount of time that each spent in the business, in the eyes of the clients, and for all practical reasons, he was the managing partner. After our conversation, we decided that he would take a business day or so to approach Mr. Jones about the possible buyout, and he would let me know how to proceed.

Mr. Smith’s demeanour was MUCH different when I heard from him the next business day; he reported indignantly that Mr. Jones offered to buy him out.

Needless to say, that situation is going to need more than just a valuation to clean it up; the partners will now have to spend money on a business attorney, who will have to unravel that business relationship and apply the various statutes necessary to determine who has the right to buy out whom.

If you have started a business partnership, and there is no formal agreement in place, shame on you. Punish yourself in whatever way you deem necessary, and then you and your business partner run- don’t walk- to a business attorney, so you can get that important step figured out.

And if you’re in the process of setting up a business partnership, now’s the perfect time to have that done- you cannot foresee the various events that will necessitate you needing the partnership agreement, but if/when one of those triggering events occurs, you’ll be glad you have the protection that a formal agreement provides.

Next week, we will discuss a major component of a proper partnership agreement- the buy-sell clause.


Of Elephants and Blind Men- Getting to the True Value of your Business

April 19, 2011

As we have discussed in the past, there are several- SEVERAL different methods of performing a business valuation. Some are more mathematical and precise in nature, while others are more subjective and philosophical. With all of these methods producing potentially vastly different results, getting to the true value of your business can indeed be a tricky proposition.

So… how do you get around the problem of several different methods telling several different stories about the potential value of the subject business?

Consider the following loose analogy, in which 5 blind men are asked to touch an elephant and describe it.

One man touches the tail of the elephant, and leaves thinking that an elephant is about the size of a broomstick with a tuft of hair on the end of it.

Another touches the trunk, and gets the sense that an elephant is about 6 ft long with a hole at its end.

Another, the ears, along with a different opinion; another, the legs, with a different opinion; another, the side with a different opinion.

If you took the opinions of any one of those men, you can be sure that:
– none of them would be “wrong”
– none of them would have ANY idea of what an elephant looks like.

What’s the key thing missing in this exercise that was given to the men? It is an overall attempt to synthesize the opinions of all of the men, combining them into one informed opinion of what the elephant is really like.

In exactly the same way, the value of a subject business is like the elephant, and the opinions of each of the men are like the results generated by each valuation method. By themselves, each opinion does not necessarily carry much weight; however, combined and considered in their aggregate significance, they create a total opinion of value that individually, they cannot achieve on their own.

By the way- you might often hear about situations where valuation specialists dramatically over- or under-state the value of a business. How does this happen? Simple- the specialists essentially grab the tail of the elephant and assume that it is representative of the entire animal.

It is sometimes due to lack of knowledge; unfortunately, it is also sometimes due to an intentional attempt to mis-represent the value of the business to suit the purposes of the person who hired them.

If you are ever in the situation where you need to have a business valued, be sure to ask the specialist about his methodology of synthesizing the results indicated by different valuation methods. If you get a glassy-eyed look, or are not satisfied with the answer that you have been provided, do yourself a favour and keep looking until you find a specialist who knows how to properly accomplish this. The value of the subject business will be more accurately determined when you find the specialist who practices this important step.


How Goodwill Is Separated- The Mechanics

April 5, 2011

Recall from the last post that I discussed the significance of understanding the different types of goodwill. It is very important to be able to quantify, given a value of total goodwill that is part of the value of a company, how much of that goodwill is personal, and how much is professional.

At the risk of losing several people forever, I am going to describe at a 10,000 ft level the mechanics of calculating the proportions of personal and professional goodwill.

For a given value of goodwill, the simple formula is:

Personal GW + Professional GW = Total GW.

Expressed in a different fashion:

% of Personal GW + % of Professional GW = 100% GW.

How do you determine what constitutes an appropriate percentage in each category?

Answer: the Multi-Attribute Utility Model.

I’ll spare you the gory details of the mechanics of the model; for purposes of understanding in layman’s terms how the model is applied, you need only understand that there are several questions that are posed for a given company whose goodwill is being analyzed. Some of those questions might be:

* What is the personal reputation of the owner?
* What does the location of the business have to do with why people give it their patronage?
* What is the age and health of the owner?
* To what extent is there physical closeness of the owner to providing the service (as would be the case for a surgeon or a massage therapist)?
* Is the owner’s name included in the business name (eg. Wal-Mart, Randall’s Grocery, Brian Walters and Associates)?
* Are there multiple locations of the business?
* Are there systems in place that allow the business to function independently of the owner’s presence?

After these questions are posed (typically about 20 or so), there is an assessment made by the valuation specialist as to:
– The importance of the answer that is sought by each question (referred to as “attributes”)
– The extent to which each attribute applies to the business being assessed.

Having gone through this process (and again, this is a 10,000 ft view of the process), the valuation specialist now has the mechanism to be able to mathematically calculate the appropriate percentages of personal and professional goodwill. A typical calculation might be:

% of Personal GW: 65%
% of Professional GW: 35%

For a given total goodwill (for example, $10 million), the specialist then applies each percentage to the total to obtain the numeric value of each category of goodwill:

Personal GW = .65 x $10 million, or $6,500,000
Professional GW = .35 x $10 million, or $3,500,000

So that’s the process- or at least a very high-level view of it. If you would like to discuss the specifics of how this process might apply to a particular situation of which you are aware, feel free to contact me.


Personal vs Professional Goodwill- A Real-Life Application

March 21, 2011

Recall from last week’s blog entry that the goodwill portion of the value of your business can be divided into two parts- personal and professional goodwill. In order to crystallize the importance of the difference between the two, let’s talk about a real-life application of the goodwill concept.

In marital asset separation, a spouse's ownership shares in a business can be the largest asset under consideration.


Consider the following scenario:

You are the part-owner of a professional practice (let’s take the law firm in the example from last week). You have decided that you no longer want to be married to your spouse, and, as is necessary in divorce situations, the value of your business needs to be determined.

The business valuation specialist needs to do the following, at a minimum:
• Determine the overall value of your business.
• Determine, based on your ownership percentage, what the gross value of your ownership shares is.
• Account for any discounts that might apply (Discounts for Lack of Control and Lack of Marketability are the most common, given a minority percentage of ownership shares)
• Based on a calculated overall goodwill as part of the valuation exercise, determine what percentage of the value of your ownership shares is goodwill.
• Given the previous step, determine what percentage of the goodwill is personal, and what percentage is professional.

Still with me?

Here’s the kicker…

Subtract the value of your personal goodwill from the overall value of your ownership shares.

That’s right- in the above scenario, your personal goodwill cannot be considered when dividing assets as part of a marital asset separation exercise.

This obviously has HUGE implications if you’re considering a divorce. If you are the person who owns the business, you need to be aware that the value of your personal goodwill will be subtracted from the overall value of the business, and you might want to rest assured in that knowledge.

On the other hand, if you are the spouse who is NOT the owner of the business being valued, you need to know that you cannot count on the value of the goodwill that is directly attributable to your spouse. This will clearly be the focus of several conversations that you will need to have with your attorney/s.

Hopefully, this provides some information for you on the importance of this issue; if nothing else, remember that it is critically important in a divorce situation to 1) know the amount of goodwill present in your business, and 2) know the percentage of that goodwill that is directly attributable to you as the business owner (personal goodwill).

Next week, I will discuss the mechanics of how a valuation specialist calculates and apportions goodwill between the 2 categories.


Personal v Professional Goodwill- what’s the difference?

March 16, 2011

Recall from last week’s post that goodwill is the value of your business that is not represented on your balance sheet- the location of your business, great employees, your own professional stature, and the longevity of your company are all included in the goodwill that your company possesses.

Let’s drill down a little beyond the 10,000 ft level, however, and talk about different kinds of goodwill.

Some professional practices can have high levels of personal goodwill

For a given company with a certain amount of goodwill (for example, yours), that goodwill can be separated into 2 kinds: personal and professional. For a definition of each:

Personal Goodwill: that goodwill that can be attributed directly to you as the business owner. This can be clearly understood in the example of a highly successful brain surgeon with a private practice.

A significant portion of the reason why patients might give you their patronage is because of the reputation that you have; in other words, if someone else were to take over your business, there is a good chance that there might be a huge exodus of clients and loss of business, because your clients were coming to you because of your individual reputation, as opposed to the reputation of your practice. Your practice would be characterized as one with a high degree of personal goodwill.

Professional Goodwill: that goodwill that exists because of certain aspects of your business, not necessarily attributable directly to you. For example- if you are a partner/owner in a professional practice (eg a law firm), there is a certain amount of goodwill built up over time by the success of your business.

Clients come to you, but not necessarily because you are there; the reputation of the practice alone is enough to get clients to use you in their time of need. There may be some people who use the firm because you are there, but if you were to leave, there might not be much of a negative impact on the business operations of the firm.

This is a typical scenario of a business with high levels of professional goodwill.

This represents the background for a personal vs professional goodwill exercise. If this appears to you to be a semantic exercise not worth going through, I would highly recommend that you stay tuned; next week, I will provide the details for a typical scenario where a goodwill analysis is needed, and you will immediately see the impact of the application of this powerful concept.

Coming next week: A divorcing business owner, and the impact of personal vs. professional goodwill.