Cutting expenses can potentially increase the value of a company, but it depends on the specific circumstances and the approach taken to reduce expenses. Here are some factors to consider:
Impact on profitability Reducing expenses can improve profitability, which is a key driver of a company’s value. However, if the expense cuts negatively impact revenue or customer satisfaction, the overall effect on profitability may be minimal or negative.
Quality of expense cuts Simply cutting expenses without considering the impact on the business can be counterproductive. Effective expense reduction requires careful analysis of each expense category, prioritizing areas that have the least impact on the business and identifying opportunities for cost savings and efficiency gains.
Impact on employees Expense cuts may require reducing employee compensation, benefits, or headcount. This can negatively impact employee morale, productivity, and retention, which can have long-term negative effects on the business.
Industry and competitive context Expense cuts should be evaluated in the context of the industry and competitive landscape. For example, if competitors are investing heavily in research and development, cutting R&D expenses may put the company at a disadvantage.
Long-term vs. short-term impact Expense cuts may have a short-term positive impact on profitability, but if they limit the company’s ability to invest in growth opportunities, the long-term impact on value may be negative.
Overall, cutting expenses can potentially increase the value of a company if it is done in a strategic and thoughtful manner that considers the impact on profitability, employees, industry and competitive context, and long-term growth opportunities. However, expense cuts alone are not a guarantee of increased value, and should be part of a broader strategy to drive growth and profitability.
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.
In 2018 the Main Street Employee Ownership Act (MSEOA) was passed. It was thought the MSEOA would allow companies to get an SBA 7(a) loan for an ESOP transition. Unfortunately, the SBA requirements to secure the 7(a) loan for an ESOP transition made it unlikely that anyone to use it. They are still using a case-by-case approval process for ESOP loans. The NCEO outlines those requirements in a recent blog post.
This June, Congress introduced H.R. 8254. The Appropriations Committee report states:
Employee Ownership.–The Committee recognizes that employee-owned businesses are uniquely structured and provide wide-ranging benefits for businesses, workers, and the local economy. The Committee notes that the Main Street Employee Ownership Act, which Congress enacted in section 862 of Public Law 115-232, requires SBA to make structural changes in SBA lending programs to ease the challenges faced by employee-owned businesses in accessing financing. This legislation also requires SBA to use Small Business Development Centers (SBDCs) to establish an employee-owned business promotion program to provide assistance on structure, business succession, and planning. SBA is directed to fully implement these requirements. The Committee further directs SBA to work with the Departments of Agriculture, Labor, and Commerce to provide education and outreach to businesses, employees and financial institutions about employee-ownership, including cooperatives and employee stock ownership plans; provide technical assistance to assist employees’ efforts to become businesses; and assist in accessing capital sources. https://www.congress.gov/congressional-report/117th-congress/house-report/393
If this bill gets passed, it may create a great opportunity for businesses to sell to their employees.
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.
We have done a number of business valuations for clients who want to gift part or all of their business interest. These valuations require a discount for lack of marketability because they are generally considered less marketable than if that person was selling their business interest.
One of the best ways to estimate a marketability discount for small businesses is through use of the Mandelbaum Factors. There are other techniques to estimate a marketability discount, but most of them require quantitative data beyond what many small companies have. Mandelbaum is qualitative–namely more fact pattern specific.
What is the discount for lack of marketability (DLOM)?
Discounts for lack of marketability can come into play anytime an interest being valued will take time to sell when using the fair market value standard of value. Keep in mind that an interest may be a whole company, a majority but not whole company stock position, a small stock position of less than 1% ownership, or even debt such as a note. Each of these interests is different and may take different lengths of time to sell. During the time required to turn the interest into cash, many things can happen that may reduce the value of the interest. With small businesses it can be as simple as the sickness or death of the owner/manager. Larger competitors undercutting on pricing or perhaps changes in customer behavior. This risk can be estimated through the marketability discount.
What are the Mandelbaum Factors?
The Mandelbaum Factors were specified in the ruling Mandelbaum v. Commissioner of Internal Revenue T.C. Member 1995-255. (Click download below to read the decision.)
In the ruling, Judge Laro determined the marketability discount by looking at specific factors that impact value and weighing them. Usually, these factors are then compared to Restricted Stock Studies findings in order to estimate a result. To simplify, Restricted Stock Studies tend to show marketability discounts from 10% to 70% with a middle ground of about 35%. Restricted Stock Studies are often based on start-ups that are quite risky because those firms often issue restricted stock. Restricted Stock is stock that can only be sold publicly after a holding period which depending on the study may have been from 6 months to 2 years. The discount that was accepted by the seller in selling the restricted interest is used to estimate marketability discounts.
History and outlook for business and industry; Financial factors such as revenues, earnings, ratios; Management; Likely holding period of interest; Redemption policy; Transfer of control; Restrictions on transfer of control; Cash distribution policy; Competitive position, nature of industry, risk of maintaining growth; Cost of public offering.
The overall trend indicates a need for the adjustment for the marketability as this interest is much less marketable than a 100% control interest.
The commonly used fair market value standard assumes that the interest being sold is sold for cash or cash equivalents quickly. Public stocks and bonds have this type of marketability but most private companies do not. This means that in many cases a discount needs to be estimated.
The Internal Revenue Service will review the business valuation and DLOMs for tax purposes, so it is important to make these valuations supportable and all calculations accurate. As always, determining a business’s value is not just a strict science based on Mandlebaum Factors, but an art too that takes Mandlebaum and other discounts (if needed) into account.
Contact Greg today for exit and estate planning business valuations.
