Tag: business valuation

Buy-Sell Agreements

 

Buy-sell agreements are the most important, but perhaps most overlooked agreement that a business can have. These legal documents protect business owners when one owner leaves the company for any reason.

Although many businesses have buy-sell agreements, they were likely drafted when the business was formed many years ago and have not been looked at or updated since. If your business has a buy-sell agreement, take it out, read it, and ask your accountant to calculate what would happen if the agreement were triggered today. Evaluate the results from both sides, as a buyer and as a seller.

  1. The first question is, is the price calculated pursuant to the agreement fair to all parties? If is unfair, it is time to execute a new agreement. (By the way, don’t assume that the younger party to the agreement will be the buyer, or that the older party will be the seller. Owners may leave their businesses for many reasons.)
  2. Another important issue in buy-sell agreements is the payment terms. Does the agreement require a lump sum payment or payments over an extended period of time? If a lump sum payment is required, how will that payment be funded? If funded by insurance, is the policy still in force and is the amount sufficient to make the payment? That $1 million term policy that was purchased when the business was formed may not be enough to cover the price today if the business has grown. Also, term insurance expires at certain ages, perhaps leaving no funding for the agreement.
  3. If the agreement requires that the business be valued, it should specify the standard of value to be used. There are big differences between fair market value and fair value. I once served as an expert in a dispute in which the agreement used the term “value.” The standard of value issue was eventually resolved, but not before the parties spent a lot on legal fees.

Don’t pay the price for no agreement

Not having a buy-sell agreement is a different kind of agreement—one to spend a lot of money, perhaps hundreds of thousands of dollars, on professional fees, and years to resolve the issues. Companies without an agreement end up letting a judge or a jury decide what will happen to the business that they worked so hard to build.

Although it is often an uncomfortable conversation to have with your partner, it is a much easier conversation to have now, when you are both healthy, your interests are aligned, and retirement or disability is not on the horizon. It is a far more difficult to reach an agreement after a triggering event, especially when that conversation is with a widow or children who are not at all concerned with fairness.

I have only touched on a few of the issues surrounding buy-sell agreements.

Take a look at your agreement with your CPA and attorney to be sure that it is up-to-date, or contact me at [email protected] with comments and questions.

What is Risk? How Does it Affect Business Value?

 

risk and business value
What are the risks in your business, and what can you do to reduce them?

According to Dictionary.com, risk is defined as “the chance of injury or loss; a hazard or a dangerous chance.” In the business valuation context, risk refers to the possibility of financial loss or drop in asset value.

In layman’s terms, the risk in buying a business is that you will overpay for it. The more risk that is associated with an investment, the higher the return that is demanded by the investor. The higher expected returns are achieved when the market places a lower value on a business that is perceived as having higher risk.

In estimating the value of a business, the analysis is based on expected cash flows and the risk that such cash flows will not be received as expected. An astute buyer seeks to minimize risk, through careful evaluation and understanding of the business he or she is considering buying or investing in. As I have said in previous blogs, the evaluation of a closely held business is no different than the evaluation done in purchasing 100 shares of a public company:

  • Will the company continue to pay dividends?
  • How much will those dividends be?
  • What will the shares be worth when you are ready to sell them?

Certain risks, such as the economy in which the business operates, are uncontrollable. Some risks, such as future competition, may be anticipated but others, such as technological obsolescence may come as a complete surprise. Many years ago, a client purchased a chain of successful photographic film developing labs and continued to operate them successfully until the advent of digital photography. The client certainly did his homework, but did not see the change that was coming. Neither did Kodak and look what happened to them!

Controllable risks to consider

If you are buying or selling a business, what are some of the controllable risks that you should look out for?  Here are a few of the more common ones:

  • Poor accounting records – A company’s accounting records should tell the full financial story of the business. With all the low-cost accounting software that is available, there is no reason that every business should not have great accounting records. A company’s books should speak for themselves; the more stories, explanations, and exceptions, the greater the perceived risk.
  • Customer concentration – Is the continued success of the business dependent upon a single customer or a few customers? If the loss of any of these customers would negatively impact the business, that is a significant risk.
  • Supplier concentration – Is the business dependent on any suppliers that cannot be quickly and easily replaced? This could be a problem if anything happens to one of those suppliers.
  • Key employees – Is the business dependent on the services of one or more employees? Are there enforceable employment contracts and non-compete agreements in place with them? If the business does not have these agreements (signed by all parties and on file), what would happen if those employees went to work for your competitor?
  • Foreign competition – Can the product or service offered by the business be purchased at a lower cost from a foreign provider? Everything from tax preparation to manufacturing to technology consulting can be outsourced overseas these days. If this hasn’t affected your business yet, chances are it soon will. What are you doing to remain competitive?

Taking these factors into account, what are the risks in your business, and what can you do to reduce them?

Everything you do to reduce business risk will be a step toward increasing your company’s value. If you’d like a fresh look at the risks inherent in your business, or to discuss the business valuation of your company, contact me at 201.655.7411 or  [email protected].

 

 

 

 

 

 

 

How to Increase the Value of Your Business

 

increase the value of your business
Reducing costs can help you increase cash flow and, as a result, the value of your business.

The value of a business is based on two factors: the expected future cash flow of the business and the risk that future cash flow will occur when and in the amounts expected.

Cash flow and risk are the meat and potatoes of business valuation. The valuation report that is produced is just a detailed analysis of these factors. Continue reading “How to Increase the Value of Your Business”

Getting a New Jersey Divorce? Beware of Spousal Double Dipping

 

Getting a NJ divorce? Beware of double dipping
New Jersey courts allow double dipping: the nontitled spouse receives their share of business value, which is based on future income, and on top of that, receives a portion of that very same income as it is earned.

In a divorce case in which one spouse owns a business, the business is generally subject to equitable distribution; that is, each spouse receives their equitable share of the value of the business. Practically speaking, this does not mean that the business is sold and the proceeds divided but rather, that the nontitled spouse receives money or other property equal to their equitable share of the business value. The problem arises in the conflict between the income stream used to value the business and the income stream used to calculate spousal support.

Continue reading “Getting a New Jersey Divorce? Beware of Spousal Double Dipping”

Using Rules of Thumb in Valuing a Business

 

business valuation
Rules of thumb may be easier, but considering factors such as cash flow and risk lead to a more accurate business valuation.

From time to time, I receive a call from someone who wants me to tell them the value of a business that they want to buy or sell. They provide a few items of information, such as last year’s sales or net income and expect that I will apply a multiple to quickly and easily come up with a value*.

What they are asking me to do is apply a rule of thumb.

Continue reading “Using Rules of Thumb in Valuing a Business”

Goodwill and Your Business

 

What is goodwill?  How is it measured?  Why is it important?  Goodwill is often misunderstood by owners of closely-held businesses.

An Intangible Asset

According to the American Institute of Certified Public Accountants’ Statement on Standards for Valuation Services, goodwill is “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”

business goodwill
Goodwill includes intangible assets such as customer relationships, trade secrets, reputation and brand.

The Internal Revenue Service defines it as “The value of a trade or business attributable to the expectancy of continued customer patronage.  This expectancy may be due to the name or reputation of a trade or business or any other factor, and in the final analysis, goodwill is based upon earning capacity.  The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets.”

What does this mean in English?  Goodwill is the value of a business, over and above the value of its identifiable tangible assets.  It is the expectancy of future earnings.  As a simple example, assume a distribution business’s only asset is inventory with a value of $100, but someone is willing to purchase that business for $500. The $400 paid over and above the value of the inventory is payment for goodwill.

The Value of Goodwill

Why would someone pay more for a business than the value of the tangible assets?  Because they expect to use those assets to earn a profit.  In the distribution business or any business, goodwill may include customer relationships, supplier relationships, reputation, location, trade secrets, or any other factor that causes the business to earn income above and beyond a fair return on tangible assets.

How can you create or increase the value of goodwill in your business?

  1. By earning consistent (and hopefully increasing) net income, which is supported by good accounting records.
  2. By establishing consistent and well-documented procedures, which will hopefully support continued future profitability. After all, someone who buys a business is not doing so because of what happened last year, he or she is buying it with the expectation of what will happen next year.

Who Owns Goodwill?

If goodwill is based on customer relationships, is the goodwill owned by the business or the employees who maintain the relationships?  This is an area of controversy because it has significant tax ramifications in the sale of some businesses, but the courts have generally held that goodwill is owned by the employee unless he or she has executed a restrictive covenant or employment agreement with the company.  If no such agreement exists, and the employee is free to work for a competitor and bring the relationship there, then the company does not own the goodwill.  However, if you are considering selling your business and do not have restricted covenants or employment agreements, consider very carefully whether or not they are necessary.

For more information on this subject, please see my article, Business Sales and Personal Goodwill.

For help in valuing your business, give us a call at 201-655-7411, or email [email protected]