Primer on Business Valuation (Part One) > Ferraro Law Group, PL

Primer on Business Valuation (Part One)

As I noted in my earlier blog entry (Primer on Property Division), when parties are attempting to divide their assets and debts, disputes often arise over the proper valuation of closely held business. Unlike automobiles, real estate or stock in publicly traded corporations; the valuation of privately held companies generally cannot be performed by simply looking up an index or applying to an online database. Instead, an intensive review (typically by a forensic CPA) must be performed in order to determine the price at which a willing buyer would sell and a willing seller would pay for a given entity.

Although most experts will concede that the process of valuing a small business is often as much an art as a science; there are clear methodologies which must be followed in order for the valuation to be recognized as a by-product of generally acceptable accounting principles (and therefore admissible in a court of law).
This article (as well as the next few blog entries) will attempt to demystify the various valuation methods such that they can be understood by attorneys and clients alike.

The Capitalized Excess Earnings Method (i.e. Treasury Method)

One valuation method which may be utilized to determine a per-share value is the Capitalized Excess Earnings Method which is sometimes also referred to as the Treasury Method. This method, which is often used in the calculation of gift and estate taxes, is sometimes used because it allows the expert to distinguish between values associated with hard assets and those comprised of intangible goodwill.
NOTE: In a given dissolution of marriage case, the distinguishing between values associated with hard assets (commonly referred to as book-value) and values associated with intangible goodwill is often crucial in arriving at an accurate appraisal for equitable distribution purposes. This is because some forms of intangible goodwill is deemed a non-marital asset of the spouse who operates the company and therefore it must be deducted from the overall value of the company. (An explanation of goodwill and its implications will be described with greater detail in a later entry.)

The Capitalized Excess Earnings Method is applied by following steps:

1. Determining the company’s book-value by adding the fair market value of its individual assets and then deducting from that figure the total liabilities of the company in order to arrive at a net asset figure;

2. Establishing a reasonable rate of return based upon the net assets and multiplying this (theoretical) rate of return by the net asset figure in order to calculate projected earnings attributable to the tangible assets;

3. Estimating a normalized level of economic earnings by averaging the company’s earnings over the length of a business cycle;

4. Deducting the projected earnings which are theoretically attributable to the tangible assets from the total normalized earnings in order to calculate the “excess earnings” which are attributable to the intangible assets;

5. Estimating a capitalization rate and multiplying this figure by the “excess earnings” to calculate the company’s intangible value;

6. Adding the net asset figure to the intangible value figure in order to get a total value;

7. The final step is to deduct a minority or marketability discount from the total value (where applicable) with the result being the fair market value of the entity.

In order to fully illustrate this method in action we will use a fictional company (JOSH ENTERPRISES) which, for purposes of this explanation, is in the business of manufacturing candy bars. JOSH ENTERPRISES has hard assets (machines, office supplies, inventory and computer software) which are collectively valued at two million dollars ($ 2,000,000.00) and total liabilities (mortgages and loans) of one point two million dollars ($ 1,200,000.00). Also, for purposes of this exercise assume that over the past five (5) years the company’s net income (revenues less expenses) was:
2009: $ 300,000.00
2008 $ 280,000.00
2007: $ 310,000.00
2006: $ 290,000.00
2005: $ 265,000.00

With these figures in mind, we are ready to start our analysis under the Capitalized Excess Earnings Method.

Step One: Determine NET ASSETT VALUE

In this case, determining the NET ASSET VALUE is relatively simple. The collective book value of the various assets is two million dollars ($ 2,000,000.00) and the total liabilities are one point two million dollars ($ 1,200,000.00). Therefore the NET ASSET VALUE (assets less debt) is eight hundred thousand dollars ($ 800,000.00).

Step Two: Apply a Reasonable Rate of Return to the NET ASSET VALUE

The second step is to apply a reasonable rate of return to the NET ASSET VALUE (NEA). This is done by assuming that rather than investing in this entity, the owner had taken the amount of the NEA and invested it into another venture in which he or she had no control or operating interest. In this case, if the owner of JE was not operating a company then the NEA would have been invested in stocks and equities in which the average rate of return was seven percent (7%). Therefore, we will multiply this percentage by the NEA ($ 800,000.00 x .07) to obtain a “reasonable rate of return” of fifty-six thousand dollars ($ 56,000.00).

Step Three: Estimate Normalized Earnings

There are very few industries where a company’s earnings will remain constant and therefore a business valuator needs to “normalize” past earnings in order to accurately predict future income potential. The simplest way of calculating an average (i.e. normalized) income stream is to simply add the past five years net income together and divide by five. (Your forensic accountant may give more weight to recent earnings in his or her calculation, however; for purposes of this example that is not necessary.)

NOTE: In most cases, the business valuator will make adjustments to the net income figures before factoring them into the normalization calculation. For example, any personal expenses which were run through the business will be re-classified as a distribution which will have the effect of increasing the normalized income. On the other end of the spectrum the CPA may determine that the owner/manager was taking less in salary then an average manager would and therefore he will make an adjustment by reducing income by the amount of the difference. These adjusted figures, and not necessarily the ones set forth in the company’s tax returns, will be factored into the calculation of normalized earnings.

In this example, the average of the net incomes over the previous five years (set forth above) is $ 289,000.00.

Step Four: Deduct Return on Assets from Normalized Earnings

In order to ascribe the value of intangible goodwill (i.e. value above that attributable to the hard assets) we will need to deduct the rate of return which is attributable solely to the hard assets from the total (normalized) earnings. In this example, our total normalized earnings are $ 289,000.00 and our rate of return on NEA is $ 56,000.00. Therefore, our normalized earnings attributable to factors other than hard-assets are $ 233,000.00. This figure is referred to as our excess earnings.

Step Five: Choosing a Capitalization Rate

The fifth step of valuing a business is the choice of a CAPITILZATION RATE. A Cap Rate is a ratio which divides the expected EXCESS EARNINGS by the TOTAL COST in order to determine how long it will take for the asset (or company) to pay for itself. This is used to value the intangible value of the company (i.e. the value of likely continued earnings separate and apart from the hard-assets).

Essentially the Cap Rate is a measurement of how risky the business venture is to a prospective purchaser. Therefore, a high-risk venture will have a higher capitalization rate then a lower risk venture (in which a purchaser would likely wait longer to recoup their money in return for security and stability). In order to determine an appropriate Capitalization Rate most experts will start with a database containing sales/valuation figures for comparable businesses. From here, the expert can increase or decrease their suggested Cap Rate based upon the individual circumstances of your business. For example, if the average Cap Rate for a drycleaner in Florida is twenty-five percent (25%) then the expert will start with that number and either increase based upon the presence of extraordinary risk factors (high debt/new regulations etc…) or decrease it based upon extraordinary stability factors (long history/experienced management under contract/ etc..).

NOTE: These may seem like arbitrary reductions/increases but your CPA will be able to back them up with data from comparable sales and/or based upon their experience in the business fields.

In our example, we will assume that businesses in the food-manufacturing industry have an average Capitalization Rate of twenty percent (20%) so this will be our starting point. We will increase this number by five percent (5%) based upon the loss of experienced management (as it will be owner operated until the sale) and another five percent (5%) because the government seriously considering (hypothetically) banning the sale of sugar products in schools (which makes up 1/8 of our revenues). We will then decrease the resulting number by three percent (3%) because of the longevity of the business (30 years). This leaves us with a Capitalization Rate of twenty-seven percent (27%). In other words, the net operating income divided by the total value will equal twenty-seven percent (27%).

Therefore, we will divide our EXCESS EARNINGS ($ 233,000.00) by our CAP RATE (27%) which gives us an Intangible Value of $ 862,962.96.

Step Six: Combine NET ASSET VALUE and INTANGIBLE VALUE

We now have a NET ASSET VALUE for our business (i.e. book value) as well as a value for our intangible assets (i.e. goodwill). We must add these figures together to come to a TOTAL VALUE. In the case of JOSH ENTERPRISES the NET ASSET VALUE equals $ 800,000.00 and an Intangible Value of $ 862,962.96. Therefore the TOTAL VALUE of JE equals $ 1,662,962.90.

Step Seven: Apply Discounts

The final step in valuing your company for purposes of dissolution of marriage is the application of appropriate discounts to the company. If sold in a vacuum the TOTAL VALUE of the company would also be its fair market value for sale purposes. In the real world, however, the TOTAL VALUE is affected by two (2) factors which may reduce its allure to prospective purchasers. The first factor is a lack of control on the part of the owner-spouse. If the spouse will own less than one hundred percent (100%) of the company then the prospective purchaser will have to take into account other shareholders in making future decisions (this lowers the value of the company). If the spouse will own less than fifty percent (50%) of the company then a prospective purchaser will have no control and likely will not pay full value for the company. The second factor is lack of marketability. If a company stock is not readily salable due to the industry it’s in, the lack of control, or even liability issues; then this will reduce the price a willing buyer is willing to pay (thereby decreasing its fair market value).

Generally, lack of control/marketability discount will reduce TOTAL VALUE by 25%-40.Therefore, you would take the TOTAL VALUE calculated in Step Six and multiply it by the combined discount to arrive at the FAIR MARKET VALUE.