You may know that the quality of your employees can greatly impact the value of your business, but are you aware how your customers are affecting your profitability? It is important for businesses to identify customers who may be challenging to work with or who may cause problems that could affect the business’s reputation, profitability, or operations. Here are some signs that a customer may be difficult or problematic:
Demanding or unrealistic expectations Customers who have unrealistic expectations or who demand special treatment or accommodations may be difficult to satisfy, and may require more time and resources than other customers.
Chronic complainers Customers who frequently complain or criticize may be difficult to please, and may have a negative impact on other customers and employees.
Late or non-payment Customers who consistently pay late or do not pay at all may cause cash flow problems for the business and mayrequire extra attention and resources to resolve.
Disrespectful or abusive behavior Customers who are disrespectful or abusive towards employees may create a toxic work environment and may harmemployee morale and productivity.
High maintenance Customers who require a lot of attention, follow-up, or support may require more time and resources than othercustomers, which can be challenging for businesses with limited resources.
Attracting the right customers is essential for the success and growth of any business. Here are some strategies that can help a business attract the right customers:
Define your target audience: It’s important to have a clear understanding of who your ideal customer is, including their demographics, interests, needs, and pain points. This will help you tailor your marketing messages and strategies to better appeal to your target audience.
Create a strong brand: A strong brand can help you differentiate your business from competitors and establish a unique identity that resonates with your target audience. This includes developing a compelling brand message, logo, color scheme, and visual identity that reflects your values and personality.
Provide high-quality products or services: Customers are more likely to return to a business if they receive high-quality products or services that meet or exceed their expectations. This includes focusing on delivering exceptional customer service and ensuring that your products or services are reliable, user-friendly, and effective.
Develop a targeted marketing strategy: A targeted marketing strategy can help you reach the right customers through channels that are most likely to resonate with them. This may include social media advertising, email marketing, content marketing, or search engine optimization.
Offer value and incentives: Offering incentives, such as discounts, promotions, or loyalty programs, can help attract new customers and encourage repeat business. However, it’s important to ensure that these incentives align with your overall business goals and are sustainable over the long term.
Monitor and adjust your strategies: Regularly monitoring your marketing and customer acquisition strategies can help you identify areas for improvement and make adjustments as needed. This may involve collecting customer feedback, analyzing data, or conducting market research to stay ahead of changing trends and preferences.
Overall, attracting the right customers requires a deep understanding of your target audience, a strong brand identity, high-quality products or services, targeted marketing strategies, value and incentives, and ongoing monitoring and adjustments to your strategies.
The best a business valuator can do is issue an “Opinion” as to business value. As such there is always the possibility of mistakes or error in business valuations.
These seven, “easy to miss errors” in business valuation can cause the business valuation opinion of value to be unsupportable or wrong. Whatever your business valuation purpose, ESOP, SBA, litigation, or estate work, make sure you know what to look for when reviewing a business valuation.
#1 – Did the Valuator use good professional judgement in the business valuation?
Business valuations have hundreds of judgment calls and assumptions. These assumptions and judgement calls are so layered that it is easy to miss many of them. This is because business valuation is forward looking. Namely, a central tenant of business valuation is that we are trying to understand the “foreseeable” future to estimate the value of the business. Because no one knows the future we look to the past and current situation to project the future.
What possibly could be more of a judgment call than predicting the future?
In addition, since a business valuation is not an actual “sale”, we have to make assumptions about who is the buyer and who is the seller along with the timeline for the sale. This is called a Standard of Value. (More on this later.) For instance a liquidation, or rush sale will have a lower value than a fair market value sale with a full marketing period.
Therefore, as you review or prepare a business valuation look at all of (or as many as you can track) the assumptions and consider if this is a fair representation of the likely future with what is known or knowable on the valuation date. In addition, since the math used to calculate the value is influenced (or should be) by the layers of assumptions make sure the calculations and final value found also make sense for the likely future of this business.
In business valuation, always apply the common sense statement,
“I would rather be approximately right rather than perfectly wrong”
#2 – In Business Valuation, Price is NOT Value
A price is what a buyer pays a seller. It is the culmination of a sales process. That process may have been a well-managed arm’s length market sale or it may have been a personal or non-arm’s length sale such as from father to daughter. Price can only be determined by buying and selling. Price involves a huge amount of emotion, luck, and in many cases deal terms such as the seller receiving part of the price over time through payments on a note.
Value is an “opinion” based on what is known and knowable to a defined standard of value and other assumptions as of a given valuation date. Usually it is assumed that the entire value is paid in cash at closing. The past is used to reasonably and rationally estimate the foreseeable future. Calculating an opinion of value does not include emotion or quality of the sale process.
Therefore price can and usually will be above or below the value. But, the two should relate. If you can’t relate them there is probably an error.
#3 – What is “known or knowable” as of the valuation date
Businesses are ever changing. Every day there are new opportunities and challenges. Therefore valuators establish a cut-off date when preparing a business valuation. That cut-off date is called the valuation date. The valuation date is not the same as the report date. The report date is the day the report is issued.
So, if my valuation date is December 31, 2019 and my report date is June 30, 2020, the only things I am supposed to consider in the six month period following the valuation date are things that were known or “knowable” as of the valuation date. Exactly what is knowable is a professional judgment call.
Sometimes the concept of a fixed date as time passes is relaxed or the valuation date is a moving target. This is common in divorce cases. Another example; if a valuation is prepared for an acquisition and a major change occurs after the valuation date the valuation may be valid as of the valuation date, but it is probably not useful to the parties.
This may all seem like silly semantics but think of the value of a sit down restaurant in Manhattan before and after the Covid-19 shut-downs. Therefore, pay attention to what is known or knowable as of the valuation date because change is constant.
#4 – Business Valuation – Standard of Value
In business valuation Standards of Value are shorthand definitions for who is my buyer, who is my seller, whose view (buyer, seller or both) are we looking at the value from and what is the time-frame for the sale.
This standardization allows business valuations to be comparable to each other and useful to reviewers and users. Standards of value are often specified by the purpose of the business valuation.
For instance, in litigation, the state or Federal rules that apply will often specify a standard of value. Valuations for tax purposes are specified to be fair market value.
Sometimes the standard of value is selected by the client. For instance for internal planning use, a client might select fair market value or synergistic value.
A few of the most common standards of value:
Fair Market Value – “The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Rev Ruling 59-60
Note that this is not an actual buyer or seller including the owner or prospective buyer of a business but hypothetical buyer or seller. Further assumptions are that the price will be paid in cash at closing and the sale will happen relatively quickly (namely the interest is “marketable”).
Fair Value –For small business use, this standard is generally fair market value of a 100% interest divided pro-rata by the ownership interest. Namely marketability and minority interest discounts are not applied. If a minority owner owns 7% of a business with a control value of $100,000 the value is $7,000. Under fair market value after discounts it might be $4,000. This standard is often specified by statute to protect minority interest holders in businesses.
Synergistic Value – “A price or potential price reflecting all or some portion of the value of synergistic benefits created through the combination of the respective entities” Shannon Pratt.
A simple example of a synergistic value is two delivery companies with half empty vehicles going on the same delivery routes. If they merge the value of the target should be higher to this buyer than other buyers because the combined entity will have higher earnings (fewer drivers, and fewer full trucks) than the target generates on its own. If many market buyers may have the synergy available then synergistic value can fall under fair market value. Usually it falls under investment value below.
Investment Value – This is the actual estimated value of a company to another known company or buyer. Investment Value is the opposite of Fair Market Value in that both the buyer and seller are known and the value is estimated to them as opposed to hypothetical buyers and sellers.
Along with standard of value is premise of value. There are two main premises, going concern where the company is assumed to continue and liquidation where the company is assumed to be dissolved.
Clearly assumptions specified in the standard of value can greatly affect the value found. Make sure the valuation calls out the correct standard of value for the purpose of the valuation and then applies that standard of value throughout the many assumptions, calculations and report.
#5 – Business Valuation – Cash Flow Normalization
For many people, cash flow is the main thing they think of when they think of business valuation.
For small business valuation the most frequently used cash flows are revenues, EBITDA or Earnings before Interest, Taxes, Depreciation, and Amortization, and SDE or Sellers Discretionary Earnings. SDE is essentially EBITDA plus all the ways one owner makes money including salary and benefits. Revenues are easy to identify but often do not indicate the earnings power of the company. Therefore they can be a less reliable indicator of value.
For business valuation, cash flows are first “normalized”. When normalizing the valuator attempts to adjust the cash flow to be similar to the cash flows used to develop a multiplier or discount / capitalization rate discussed below. Basically to create an “apples to apples” comparison.
Normalization involves several types of adjustments, comparability, one time or non-operating, and discretionary.
Comparability adjustments are to adjust how the company keeps their accounting records to fit the cash flow definition being used.
One-time adjustments are unusual and non-recurring expenses or revenues such as a loss from a onetime lawsuit. The valuator would remove the loss from the cash flow as they are unlikely to be predictive of future cash flows.
Discretionary adjustments are adjustments an owner may make for his benefit like having a non-working spouse on payroll. This situation may not occur with the new owner and are discretionary to the current owner.
Cash flows for the last three to five years are typically reviewed and adjusted.
Then depending on the valuation method being used the historic adjusted cash flows are weighted.
For instance if I have three years of data being reviewed for a business valuation, I could weight each year’s cash flow evenly to come up with an average or I could select one year to come up with one number for my future cash flow. The other alternative used in some methods is to develop a projection of likely future results. With small businesses this can be difficult. How the cash flow is selected or determined can greatly swing value and needs to be carefully considered.
Either way, the valuator is trying to estimate a future cash flow. Therefore even if historic results are strong but an intervening event has occurred (think Covid with sit-down restaurants, or a convenience store that lost its lease), the future cash flow may vary from the past.
In the end, cash flow in most cases is one of two major factors used to calculate an indication of value. All of the assumptions and adjustments, and perhaps even the calendar years of data (3 years or 5 years or some other figure) used to determine trends of the company need to make sense and be reasonable.
#6 – Selection of the Multiplier or Discount/Capitalization Rate
In business valuation a great deal of time and effort is spent on the financial information or numbers. But, behind the numbers is a business that generates the numbers. This business may have great systems and people and be highly resilient or it could be a few overworked people doing everything from the seat of their pants. Evaluating the business itself and what we call, “soft” factors is very important. This information is then used to determine the risk factor of the business. The risk factor is then applied against the cash flow selected to determine value. For example in the market method market comparables are reviewed against the subject company (both financial information and quality of the company) and then the starting point indication of value is determined using the formula below.
Market Method: Cash Flow X Multiplier = Value
It is easy to hedge a risk factor a little high or a little low. If the valuator also hedged the cash flow in the same direction the indication of value can be seriously different from what would be the correct value found. Therefore always apply a sniff test or judgment test to the multiplier, capitalization rate, or discount rate used.
#7 – Business Valuation – Weighting of Methods to Determine Value
Calculating the indications of value is simply applying the cash flows to the multiplier or discount or capitalization rate. Often multiple business valuation methods will be used to estimate value. Then sometimes one method is selected or the different methods will be weighted to come up with a value.
For instance the value found under the market method is $200,000 and the value found under the income method is $250,000 the valuator might pick either method or weight them. If weighted 50% each then the value would be $225,000. It is important that there be a valid logic in this weighting that ties into issues with the valuation methodologies, the overall company situation and likely future based on what is known and knowable as of the valuation date.
Finally the value estimated based on cash flows should be adjusted as appropriate for extra assets included or excluded in the valuation method assumptions. A typical adjustment could be for inventory.
For instance, with restaurants inventory under the market method is often added to the indicated price and depending on the source of comparable data.
Working capital with small businesses is another source of adjustment. In small company transactions owners often keep the working capital (cash and accounts receivable). As companies get larger working capital is more likely to be included in the price. Again, this is another area where professional judgement must be applied particularly with companies between one million and five million dollars of value.
Each method should be reviewed and the weighting itself should be reviewed for reasonableness. Any adjustments for included or excluded assets should be made and also reviewed for reasonableness. Valuation it an iterative process.
Always finish developing or reviewing a business valuation by remembering Tip 1 – “I would rather be approximately right than perfectly wrong.”
Conclusion:
Business valuations are quite technical. If it is your business and your life being affected by the valuation, or if you prepare or review business valuations, you want make sure the valuation is right.
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” covers many professional judgement scenarios, explains calculations and standards in great detail and addresses other important valuation issues. You will also have web access to download sample reports, calculators and checklists. You will reach for this complete resource time and again.
After a recent seminar “Valuing Small Businesses in the Shadow of COVID-19”, I took time at the end to answer some questions from the attendees. Here are some of the questions (and answers!) on using the Income Method to value small businesses that I felt might be most helpful for other seminar attendees as well as business valuators, CPAs, lawyers, and consultants that work with business valuations.
Do you believe projections and forecasts for the discounted cash flow income method of business valuation use will be less reliable during the Covid-19 Pandemic than before?
It is very difficult to estimate reliability of projections for business valuation outside of comparing a company’s prior projections with actual results. Most small companies do not have that type of data or the projections prove to be unreliable pretty much all the time. Therefore I do not believe most projections are less reliable due to COVID-19. There are reasons to believe they may be more reliable. I suspect in most cases much more thought and support will be provided in creating the projections and final forecast. For many companies, instead of being a “add 5% to last year” situation (we have all done it) much more strategy and foresight will go into the whole planning and projection process.
In all events all projections and forecasts for use in an income method of business valuation need to be reviewed carefully from the point of view of, “is this the absolute best that can be done” with what is known and knowable. In the “The Art of Business Valuation”, much time is spent on reviewing projections as it is always a difficult area with a high level of professional judgment.
Aswath Damodaran models deal with changing growth rates and discount rates in the future in order to estimate business value using the discounted cash flow income method. See his discussion of the three state dividend discount model and the H model. Do you agree?
Damodaran is clearly a sage in the field of business valuation. He deals almost exclusively with public and extremely large private companies that may go public. That is entirely different from valuing small and micro businesses typically with revenues under $10 million. Certainly if you are working with a company that can provide a quality projection as a base for use in a discounted cash flow analysis, adjusting the cash flows and the discount rates over time is a reasonable way to estimate the value. In fact, if the data is highly supportable, the discounted cash flow method is theoretically the best method. Of course this is fact and situation dependent like all business valuations.
Many Companies and most small companies cannot give you a reasonable starting point projection or forecast. From my point of view, if I do not have a reliable projection to start from, it is usually best to use a single period valuation method such as the capitalization of earnings method with proper adjustments. Therefore in the proper situations, I agree with Damodaran. But for most micro and small business valuations we will not have the starting point data available to us to use the discounted cash flow income method of business valuation.
On last comment. I will frequently run estimated discounted cash flow models with various potential earnings streams to get an understanding of a companies range of values under possible scenarios. But to me, these are sanity checks and/or information underlying my professional judgement not final valuation methods. A useful tool but if I can’t really support the cash flow, it is not a final valuation method.
Have you ever had a situation where the Company Specific Premium in the Income Method of Business Valuation is negative because risk is lower than normal?
Absolutely but it is quite rare. Every now and then we find a company that is so locked in with its customers (often referred to as “sticky” ; for example, credit card processors can be sticky because they are written into your website) and so well organized and profitable that the risk is below the average public company. But, that is very rare. If you find that company, make sure you really build a well thought out case for your adjustment because it is likely to be doubted. Clearly explain why your company is different and why it should stay that way in the foreseeable future.
More webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic and other business valuation topics are being scheduled in the upcoming weeks. If you are interested in participating, please visit our Upcoming Events page
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book, published by Wiley, is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
How can you tell if a business valuation is correct or if it is likely to be biased, wrong, or outright rigged?
In the majority of business valuations, the business valuator follows accepted standards and delivers a supportable and unbiased valuation.
Unfortunately, a few business valuations are incorrect or inappropriate. Often this result is more because of inexperience or unrecognized bias rather than outright intention.
The wrong standard of value. Standards of value are standardized assumptions around who are the agreed upon buyers, sellers, timing, and other details of a sale. The wrong standard of value will subtly change many things in the valuation and often lead to an improper value.
The wrong valuation date. The valuation date is the cut-off date that the valuation is done through. For some valuation purposes the valuation date is critical. For instance, consider the value of a restaurant serving a tourist destination on a far-off island the month before Covid-19 shut downs and the month after. For some purposes the valuation date moves. This is common in divorce. The wrong valuation date can result in a wrong value.
The cash flow being applied against the wrong multiplier or discount rate. For instance a SDE (Sellers Discretionary Earnings) cash flow being applied to an EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) multiplier; a non-tax adjusted cash flow being applied to a standard tax adjusted build-up. This can greatly skew value and is not always as obvious to spot as it sounds.
Too Good To Be True, almost miraculously better or worse current year (or previous year) results than earlier periods. In some industries, many aspects of the accounting statements are based on allocations that can be tinkered with. Are gross margins consistent, were all expenses entered, are the period cut-offs correct? Does the economy, industry, company factors and more support the numbers? There may be a very good reason for the change in results, but make sure the situation makes sense.
Suspicious add-backs, one-time events, and so on. Adjusting entries to create “apples to apples” financial statements for comparisons to market data or discount rate data is essential. It is also a major area for error and trouble. Make sure comparability, one time, and discretionary adjustments meet the definition for the cash flow being used and are properly supported.
Cash flow weighting that is not supported by facts. Both the market method and the capitalization of earnings method weight historic cash flows to estimate a future cash flow value. This weighting should be done to tie into expected future results as reasonably influenced by the past and future expectations. Intervening events can make historic cash flows susceptible. This calculation is easy to miss and can greatly swing results.
Hockey stick projections. Similar to miraculously better financials are projections into the future. Companies that claim they are going to “take-off” next year. Certainly that could happen but support should be very strong and the discount rate should be higher to justify a value found.
Unusual or doubtful discounts, capitalization rates, and market data multipliers. These are all adjustments to reflect the risk of making or not making the required cash flow return into the future. The comparison set needs to be reasonably tied into the situation with the subject company. While the discount rate or multiplier is a simple number, estimating it requires experience and professional judgement.
A final value after all adjustments and balance sheet adjustments that is above a 100% financed business at 8%. This is extreme, but it happens, most often with very high inventory or receivables businesses. Again, the finance method is a great sanity check. In the Finance Method rule of thumb, you work back from the cash flow to estimate the loan principal amount it will support.
Cash Leakage. At the other extreme, a long-term high revenue business in a “cash” industry with very low gross margins and no value. While it could be a huge discounter, it may also indicate cash leakage and requires additional review.
Cherry picking. Namely, almost every choice was favorable to very favorable for a higher or lower value. Consistent but unjustifiable small gains or losses at every turn can greatly change the value found.
All of these issues, other than the first two issues, could be explainable and even correct. But, if these factors are present, look hard and ask questions before signing that the value found and the report is correct.
Conclusion:
If you are reviewing a business valuation you should make sure it is correct. The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has 400 pages covering many professional judgement, calculation, standards, and other important valuation issues along with access to sample reports, calculators, and checklists downloadable from the web. This will be the one book you will reach for if you value or rely on valuations of micro or small businesses with revenues under $10 million. The book published by Wiley is available at your preferred bookseller. More information can be found at www.theartofbusinessvaluation.com
Finally Greg Caruso, JD, CPA, CVA, the author is always available to prepare (or review) business valuations for all purposes and situations.
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Recently I presented “Valuing Micro and Small Businesses in the Shadow of COVID-19″ as a webinar training for Business Valuation Resource members. As always, I provided time at the end of the session for questions from attendees. This group had some very thoughtful questions. I thought perhaps others would benefit from our discussion.
What do you mean by “poor financials?” Do you mean a lot of personal stuff is run through the business? Or a general ledger that doesn’t balance and off balance sheet assets / liabilities?
Each of those issues creates poor financials plus many more. Many micro and small business owners manage by walking around. They have a few leading indicators they watch (maybe sales, collections, production). From those, plus being in the middle of the business, they know how they are doing. This knowledge does not translate well for us, as we are not in the middle. Therefore, we have to work harder to really understand what is going on and how to adjust the deficient financials so they are reasonable and workable.
What sources of data do I use for the local economy?
I use the Federal Reserve Beige Book, published for each district. It is anecdotal information but I find it useful.
Another one I will use for cyclical and real estate related is State Board of Realtors sales data. Often this can be obtained at a local level, if that is more meaningful for your company. The data here impacts everything from construction, remodeling, furniture sales, equipment sales, etc. in a local or state market.
Also, the quarterly BizBuySell Insight Report offers data on many market areas with prior reports available for many years to allow comparisons. The number of sales can be used as an indicator of the difficulty or ease of selling a small business.
Local information can be gleaned from many sources. Many federal agencies, states, universities, and state oriented non-profits publish data that might be indicated for the Company and industry you are valuing.
I have been spending more time analyzing debt service (for example: Can they pay back the debt? If so when will they achieve a profit given high debt levels? Will they need more debt to stay afloat?). Do you have any thoughts on that?
Certainly for high debt companies, or companies with lumpy cash flows, (i.e. a few large clients or projects that have endpoints like construction contractors that do a few large projects each year) understanding the balance sheet is very important. Current assets on the balance sheet (particularly cash reserves) provide resiliency and the ability to meet payments when times are tough.
Another thing that needs to be reviewed with companies with debt is the terms of the debt. Many small companies use lines of credit like long term financing. Also, even long term loans often contain clauses allowing the lender to recall the entire amount due, if covenants like minimum earnings are not met. The result can be a company that is meeting minimum cash flows to survive falls into default on their loans creating serious going concern issues.
In most cases (but not all), we do not have data to make a final determination on going concern issues. But a company that has a reasonable level of going concern issues is going to have a steep discount versus companies with a clear path forward.
I saw a few companies with low, negative earnings (-30% to 50% and high revenues multiples in the range of 3-4x. This looks funny for a service company. Since I don’t have historic data or projected data how can I make sense of the pricing relationship?
Without more data, I’m not sure. And perhaps you can’t. Some technology codes do have the types of companies desired by Google, Apple and the like and these may contain synergies that frankly I don’t completely understand how to assess.
Assuming there are enough comparables, I recommend several things though before you throw up your arms in defeat.
Try sorting the data several ways. Use different cash flow minimums and minimum and maximum revenues and see if the results look different. Sometimes I get an understanding of the data doing this and it is easy within the DealStats .
Assuming your firm is profitable sort with a minimum cash flow that is somewhat near your cash flow (i.e. if your company as a 15% SDE profitability (SDE/Revenues) and a minimum revenue sort of $1,000,000 then perhaps you require an SDE of $75,000. Since your company is profitable, these comparables will be more like your company.
Always chart the companies by cash flow profitability (Cash flow being used/Revenues). This will usually provide clear trends that are different from what might be implied by the charts shown in the various databases.
Three more webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic are scheduled in the upcoming weeks.
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
