The most important step in valuing a business is to take the time and ask the right questions to truly understand the underlying business.
By Matthew Krofchick, Business Valuator
- Try and figure out the business’s normalized earnings or cash flow.
- If the business is relatively stable, capitalize that number; if it’s expected to change over the course of the next few years, do a discounted earnings / cash flow.
- If that number is less than the fair market value of the business’s net assets, abandon it and do an asset approach.
- Sometimes, we’ll look at the market approach through either a comparable public company or precedent transaction approach.
That more or less describes the lion’s share of our valuation assignments and probably those of most other valuation professionals. The danger though in running down a valuation checklist like this one is that you could easily go through the exercise of churning out a value estimate without bothering to take the most important step: truly understanding the underlying business.
That may sound like a trite remark, but we’ve had a number of files cross our desks where we have been asked to evaluate and critique the valuation reports other valuators had prepared on behalf of one of the separating spouses. This article summarizes the salient points of two such cases and discusses the one shortcoming that each report shared: they missed the business’s off-balance sheet assets.
In-Process Research and Development
The first business was a wholesaler of software and hardware products. The opposing expert had produced a thorough valuation report that we thought adequately estimated the value of the company’s operations, so it wasn’t immediately clear that a critique report would have added any value to the proceedings.
Nevertheless, we started conducting our own investigations and in the course of interviewing the business-owning spouse and examining the company’s general ledgers, it became apparent that significant amounts of money were being invested in developing a software program that would one day become a new, online method for selling software licenses. This revenue stream hadn’t yet begun to bear fruit but would subsequently go online and generate a significant portion of the business’s overall revenues.
The issue here is that while the company expensed these development costs in accordance with GAAP, they were not explicitly represented as an expense on their income statements having been grouped in with other administrative costs. And of course, from a valuation perspective, these aren’t really operating expenses but costs that should have been capitalized to the balance sheet to represent the value of work-in-progress.
Because the software hadn’t yet been completed and was therefore generating no income on the valuation date, it was impossible to determine value based on the present value of future cash flows. In cases like this, value should be determined using the depreciated replacement cost approach, which relies on the principle of substitution and recognizes that a prudent investor would pay no more for the designated asset than the cost to reproduce or replace the designated asset with an identical or similar unit of equal utility.
In this example, we identified off-balance sheet assets as a result of carefully developing an understanding of the subject company. In the next example that follows, we identified off-balance sheet assets in the form of key personnel as a result of understanding a particular industry.
The assignment in question involved a firm whose president and majority owner was one of the divorcing spouses. Unlike the previous example, there was considerable disagreement with the report prepared by the opposing expert, who adopted an asset approach and argued that no goodwill existed in the business because of the firm’s short history, loss of a major client, and reliance on the presence of the divorcing spouse to drive business.
Now, there is a legal argument to be made that value in a family law context assumes that in the notional market, valuators should assume that parties would enter into reasonable non-competition or employment agreements in order to maximize value. But in a valuation context, a simple understanding of the subject company’s industry is enough to effectively refute this point.
To see why, we analyzed dozens of public acquisitions of businesses operating in the subject’s industry on and around the valuation date. In doing so, it became evident that one of the primary goals in the purchase of these types of businesses is to retain key individuals and commercialize the personal goodwill they have built up. This is a feature particular to this industry in which you generally aren’t buying assets or cash flows, you’re buying people, and the value of these people isn’t represented on any financial statement.
In this case, understanding the industry was essential to provide insight into how a transaction would be priced and what key assets would be involved – which turned out to be incredibly important because in the absence of that understanding, other, more traditional valuation approaches would have been more appropriate.
Conclusion: Missing Off-Balance Sheet Assets
Not all companies will have off-balance sheet assets, but those that do may be quite valuable. The good work you put in interviewing a client, asking the right questions, understanding the industry in which the company operates, and doing your research will help you identify these assets in the first place. Once the off-balance sheet assets is identified, the next step is determining the value of this asset and see how that impacts the overall value of the subject company.
Matthew Krofchick CPA, CMA, CBV, CMC, CFF is a business valuator and Principal at Krofchick Valuations. Matthew specializes in forensic accounting including income determination and business valuations for matrimonial purposes. His work includes complex tracing analysis, income determination for child and spousal support calculations, pension valuations, and business valuations. www.kval.ca
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