“Your key people are all going to retire when you sell the business? Who the heck is going to know how to run the business?????” This is not a conversation that you want to be having as a buyer or seller.
If you are trying to buy or sell a business, you know that the key people who make the business run can be an important part of the value of the business. For most small businesses the value of the company goes home every night and you hope it comes back the next morning. Of course, now the employees may just work from home and not come in but the concept is the same — employees are a huge part of a business intangible value. As a seller, your business has more value if your quality staff is staying after you leave. Your business cannot function without knowledgeable management and trained competent staff that are reliable. Here are 4 ways key people fit into business valuation.
Employees are part of the valuation.
Businesses are people applying processes to make profits. Looking at the basic market method business valuation equation, Cash Flow x Risk = Value, employees impact BOTH sides of the equation. On the one side, employees drive the processes that create cash flow. On the other, the risk of loss of the institutional knowledge that is in your employees heads is a huge factor in the risk component of value.
Employees create value.
Few small businesses make money based on their hard or fixed assets. Yes, you need those assets, but ask most clients why they use a certain business and you will hear, “We use this business because they provide great service.” Great service comes from good people. The price may count, but quality includes the quality of the service your people provide.
Employees are related to growth.
In addition to quality management, more focus is currently being given to mechanics and trained technical staff. The ability to find and keep new trained or even trainable personnel is one of the biggest growth limitations.
People are your value.
While many owners can’t imagine it, the business is not the owner. In fact, in order to have value a business must be able to operate without the owner. Therefore you must keep your people. In a recent post, I explored how you can create value through your employees (which is something you need to do long before you begin selling your business).
When we evaluate businesses, especially for tax and gift purposes, employees represent the single most important factor when calculating a business’s intangible value. This is value that you want to keep for yourself as your business grows or a value you want to include for future partners in or owners of the business.
Contact me today to learn more about business valuation and what your company is worth.
By Greg Caruso, JD, CPA, CVA, The Art of Business Valuation, Harvest Business, LCC.
Here at Art of Business Valuation, Harvest Business, LCC, we evaluate businesses for a variety of reasons, including Small Business Administration (SBA) loans and Estate and Gift Tax planning. Here is a brief summary of a three recent business valuations by the business valuation firm done by Gregory Caruso, JD, CPA, CVA, lead appraiser.
Estate and Gift Tax: Home Nursing / Eldercare Business Valuation
The business is a franchise of home nursing and eldercare company with several locations. The company had good relations with several hospital systems, which make constant referrals, driving new customers to the business. On the personnel front, the two owners and three strong upper middle managers made a good management team. They ensure consistent timely staffing and care. At this time they needed an evaluation because one owner wanted to gift his part of the business to his children. The buy-sell agreement was being modified and new restrictions were evaluated for estimating the discount of lack of marketability (DLOM) and the minority interest discount calculations. The business valuation cash flow did have some issues around reasonably supporting owner cash flow add backs and these were favorably resolved.
SBA Business Valuation: Equipment Rental Company
The company primarily rents construction equipment, tent rental, and party and catering rental items. In general, these companies tend to be seasonal where summer presents stronger business and more income. This company experienced even more of that phenomenon, as it is near a popular summer beach resort. COVID-19 reduced tent and party rentals, but increased construction equipment rentals. Because of this, the equipment rental company appeared to have an almost typical year. The selling owner had several businesses and had put very little time into this company in recent years. This sale was a first step towards his retirement. The company was being purchased by a long term manager and the purpose of the business valuation was to support an SBA 7(a) acquisition loan.
Business Valuation: Plumbing, Mechanical HVAC Service
The company primarily provided HVAC service work to a large base of residential homes and some light office space in an exurban community. They had $6M in revenues and are a highly profitable company. Much of their business was made up of small service and equipment replacement jobs, with some service contracts. They are particularly effective in internet marketing systems and have good Google and related reviews. They also had a good employee situation with plenty of trained techs. The purpose of this valuation was for partial bank financing of a family transition.
Harvest Business, LLC also commonly called The Art of Business Valuation is an expert business valuation firm that provides business valuations nationally. Our lead valuator Gregory R. Caruso, JD, CPA, CVA, has performed hundreds and hundreds of business valuations and provided training and continuing education for leading business valuation, accounting, and legal programs. Your business value is worth our quality service and experienced business valuation judgment. If you have any questions or need a business valuation for any purpose reach out today.
We all know the story: a business has a detailed cash flow projection that seems totally sensible. Then, something happens, and the company does not make those projections. The idea that a company might not make future projections represents a risk in business valuation, and something that as valuators we have to examine. Risk can come from many sources. It can also be quite pervasive in small business valuation. I want to review concentration risk, or where there might be limitations on revenue for a business. Concentration risk can occur in many places, some of which are not always immediately apparent. Here are six concentration risks.
Limited Market Risk
Where is a company selling? Sometimes, the market is only so big. For example, Hilton Hotels have a presence all over the world, which provides them a cushion from any one particular market (say Europe) having difficulty. However, a local franchisee is in one market, and if that market gets overbuilt or has many hotels in competition, it might be harder to find customers or recover.
Limited Product and Service Risk
What is a company offering or selling? A business can have a limitation based on what they sell. During the Covid pandemic, Costco was considered essential because it sold groceries. However, they also sell many other products including clothing and outdoor gear. A small retailer that only sold outdoor gear or clothing was not considered essential and forced to close. Similarly, an accounting firm that had a majority of clients in restaurants would have been more adversely affected by the pandemic than one that had clients in many different industries. Being concentrated in one product or service can be a risk.
Limited Management Risk
Who are the managers? The nature of a small business is that it is small. Most small businesses tend to have a limited number of managers. This means that the loss of any key person can disrupt the business.
Customer Concentration Risk
Who are the customers? Many small businesses can grow quickly by providing services to a few larger companies. However, if their revenue only comes from a small number of clients, then the loss of one of those clients could represent a significant amount of money. Too high customer concentration can be a risk.
Referral Concentrations Risk
Where does the business get new customers? This can be much harder to spot but just as deadly. In one instance, I saw a business with many customers but they all came through one or two referral relationships. If one or both of those relationships stopped referring new clients, where would the business get new clients? Clearly this can increase risk of loss of revenues.
Supplier Concentration Risk
Where does the company get their supply? Anytime a business has only one supplier–particularly if the supplier is hard to replace–that adds risk. For instance, a sole supplier in China that gives good prices is far riskier than many local suppliers.
How should we address these risks in our SBA business valuations, Estate and Gift tax business valuations, and Exit and Succession Planning business valuations?
Market Method
In most instances, companies of a similar size can be searched and selected for comparison. Often these companies will be subject to the same concentrations and limitations. Therefore many of the concentrations I mention above will already have been factored into the multiplier. But you have to take care and examine the sample set. This helps you make sure that if there are outliers and factors that may create a variance, you take them into account and bump your ultimate selected multiplier up or down as appropriate. With experience this process becomes much easier, but in all cases it requires thought and judgment.
Income Method
Data for the income method is primarily derived from public company information. Most public companies are very large (even “small” public companies are usually huge compared to private firms). They might also not have the above concentration risks, and definitely wouldn’t have them to the same degree as a small, one- or two-location business. For this reason, you must adjust for these factors in the Company Specific Risk Adjustment when using build-up methodologies to determine the discount or capitalization rate. Some valuators have tried to create a factor analysis to calculate the Company Specific Risk Factor, but to date on one has been successful. This adjustment contains a lot of professional judgment, where experience is key.
There are a variety of reasons why businesses need to get a valuation. One of the most common is for SBA 7(a) loans, but they can also be used in getting other loans, or for succession planning, exit planning, and value growth. Here are three different recent business valuations we completed.
Floor Leveling – Concrete Flooring Specialty Construction Contractor Business Valuation
The team at the Art of Business Valuation, Harvest Business, LLC prepared an opinion of value for a specialty concrete floor leveling contractor where the owner was planning to sell to a key manager over a period of years. The complexity of this business valuation arose because of large variations between the cash basis tax returns and the internal accrual based financials which the parties agreed were trustworthy.
The flooring contractor was highly profitable over the review period but there were wide swings between good years and bad years. There was little growth over the period, yet the company was very consistent. Therefore, we averaged the cash flows over the period reviewed in order to project the future cash flows. Both the market method cash flow and the capitalization of earning method were used and weighted to determine the final conclusion / opinion of business value for the concrete floor leveling specialty contractor.
Liquor Store – SBA 7(a) Business Valuation
What can we say? With the pandemic, we have done a bunch of SBA 7(a) loan business valuations of liquor stores in the last year. SBA 7(a) loans for liquor stores can make sure that they have the capital they need for a changing market. Many of the stores we have evaluated are in New York and Pennsylvania. Liquor stores often are great businesses in small towns.
Home Builder & Developer — Business Valuation Opinion of Value for Gifting & Estate Planning Purposes
A home builder and developer in the Carolinas needed a business valuation to begin gifting business interests to his son. One major issue we found was that 2020 was an off-the-charts successful year for builders because the pandemic increased demand for homes (especially new homes). However, this success was not likely to be repeated in the future. For example, the company was having a hard time locating new lots to build on and high costs and low availability of construction materials were impacting future profits. Of course, this was somewhat offset by the fact that everything was selling with reduced sales expenses.
We were asked to value the home building operations and to properly discount the minority interest for lack of control and lack of marketability (DLOM) which was to be conveyed. To perform the discounting, we reviewed Restricted Stock Study Quintile Analysis combined with a Mandelbaum Review and Chaffe’s and Finnerty’s Put Option Analysis.
Each business valuation–no matter the industry or company–is an art, not a science. We bring years of experience and a complex understanding of all of the elements of business valuation. Contact us today to learn more about our business valuation services.
Employees are all over the news for demanding flexibility and better employment terms. For many businesses, employees are both the largest cost and the source of most of the intangible business value. Here is a primer on how employees and your business’s intangible value are related.
What is intangible value?
First, let’s start with the basics. Intangible value is all of the value of your business that is not represented by identifiable tangible assets. A business’s intangible assets are things such as money, furniture, computers, equipment, or real estate. Namely, anything we cannot see or touch.
What really creates intangible value?
When we talk about value (tangible or intangible), we are talking about the future profitability of a company. In reality, this future profitability is always about people, or employees who maintain and grow a company or business. You may say, “But Greg, Microsoft can just sell more copies of their software and make profits with very few people.” This is true in the short term. However, in a few years, no one would buy Microsoft products because they would already own it.
Companies need to keep updating and improving what they offer. Then, they need to sell, manage, and lead the product lines or offerings. Otherwise, the overall company or the value of the company would quickly fall as customers move to newer or easier-to-use products. (Remember the decline of the Blackberry for the iPhone?). All companies need “forever and continuous improvement,” or they will get left behind.
You employees create all of your intangible value over time. This is an especially important point for small business owners to remember.
How can you increase your intangible business value through your employees?
In today’s tight labor market, employees (and good employees) are especially important. But really, they are always important for your business’s value. There are simple ways to increase your business’s intangible value through your employees.
Hire the best. Train them, grow them, and keep them. This is hard work and if you are really successful you will lose the occasional well trained person but really, what is the alternative?
Compensate them well. I say compensate rather than pay, because benefits like flexibility, titles, and non-monetary compensation (i.e. retirement plans or health insurance) are often just as important as salary. Just remember, your competitors are lurking for your stars and they will pay more – at least on the hire date.
Create benefits that lock employees in. For instance, if your company gives large bonuses, pay the bonus over 3 years in thirds. If an employee chooses to leave, they are also leaving a big bonus behind. However, remember that if you need to lay them off, you will have to pay them the full bonus. Another option is to create a stay agreement, where the employee receives a bonus if they stay for 2 years under new ownership. Remember, ownership can change for voluntary or involuntary reasons.
Remember the huge cost of new hires. Although you are hiring the best, they will still need time to adjust to your company. By the time they are found, trained, and really up to speed, they are even more valuable. Don’t be chintzy with your best people.
Hire slow and fire fast. This might be the most important advice for any business owner. Back to point one–hire the best, even if it takes time. Then, don’t be afraid to let people go. How many times has a hire that did not feel like a fit at the end of the first week actually make it on the team? Yet I bet you put tons of time “trying” to get it to work. Let those people go after two weeks, not six months.
Contractually protect yourself. In most jurisdictions, properly prepared non-competes or non-solicits can be used to protect your firm from the loss of clients that might leave with a key employee. In my mind, these employees should be able to work in the field but not leave with your clients. The specifics of these provisions vary by state, so make sure to ask your lawyer.
Creating value for your company through employees means using both the carrot and the stick. Take your time to hire great employees. Then, keep them growing by compensating them well and keep them around by structuring benefits and contracts that keep them around and protect you. And don’t be afraid of letting employees go if they aren’t great, no matter how hard it is. Employees are the single most important part of a business’s intangible value, a value that you want to keep for yourself or for future partners in or owners of the business.
If you are buying or selling, or adding or removing a partner from a business partnership, you may know that the business needs to be valued. In very generic terms, this means creating a financial model of your business and estimating a value. Business evaluators use three business valuation approaches to value different businesses. But how do you know which valuation approach is best for your small business?
Here are the basics on the 3 approaches to business valuation, and which businesses they work best for.
The market approach uses substitution of market sales.
The market approach is the primary way to value small and very small businesses. The valuator will substitute comparable market sales from similar companies that have recently been sold to the company being valued. This calculation includes comparing cash flows and financial information with information about how the company is structured, the industry, and overall economy. For example, if a small government services provider is looking to determine their value for the SBA, a valuator would compare their size, management team, cash flow, and financials to a group similarly sized business in the same industry. For more information on this approach click here.
An income approach is based on cash flow.
When valuators use the income approach to find the value of a small business, they focus primarily on cash flow. The income approaches estimate the business value to an investor who could invest in anything from a government bond to a small business. This means looking at how much money a business is making and the business risk compared to other investment risks. Because most people who are buying or selling a business are interested in knowing how this business compares to other businesses this approach is the most used approach. By looking at the historic cash flow and income of a business along with many other business factors, valuators estimate future cash flow and the risk of obtaining the cash flow. From those inputs, they can estimate a value. For more information click to ….
The asset approach estimates the business’s value through assets.
For some small businesses, their value may lie in the assets they have. For a construction company, this could include equipment; for a commercial real estate company, it could include their properties; and for a tech company, it could include intellectual property. The asset approach is often used when there is not sufficient cash flow to use the income or market approach and basing the value on cash flow would not adequately estimate the value of a business. For more information on this approach click here.
The reality is that a professional valuator looks at your small business and all the available information, and uses the approach (or combination of approaches) best suited for your business. Each of these three models can be useful and each can be used in a misleading way. This is why all the models are helpful but none are perfect. As valuators, we impartially use valuation models to help business owners understand their value, whether it is for an SBA 7(a) loan approval, dissolution of the business, or establishing a partnership.
