Valuing Intellectual Property of an Early Stage Company

Congress shall have the power to promote the progress of science and useful arts, by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries

 US Constitution, Article 1, Section 8, Clause 8

The Issue

Intellectual property (IP) was recognized as having value by the founding fathers of the country.  As intangibles and intellectual property become the true source of where corporate value lies, correctly valuing IP takes on an increased level of importance.  IP refers to creations of the mind and the related rights to use these in commerce. While it certainly includes patents, trademarks, licenses and permits, it also includes internally developed knowhow related to manufacturing a product and/or developing a service.  Professor Baruch Lev of the Stern School at NYU has indicated that a significant percentage of the value of public firms is attributable to various types of IP, the bulk of which does not appear on their balance sheets. While the contribution of IP to overall firm profitability varies, what we do know is that it provides corporate owners with a decided competitive advantage which allows them to earn rates of return that exceed their respective costs of capital.  The upshot is that firms that have IP that is long-lived will also have market values of equity that far exceed their corresponding book values.

In cases where the firm is a startup that has IP but little or no revenue, valuing the IP is both complex and difficult. Because of these facts, the value of startup firm IP is often based on its reproduction cost. However, in those cases where there is a demonstrated market for the firm’s product that incorporates the IP, basing the IP value on its reproduction cost will almost certainly undervalue it. The reason for this outcome is that the return to the owners of the IP will likely be very high. Just think what the revenue might be if the owning firm licensed the IP to another firm and collected a 2% royalty rate on licensee sales that incorporated the IP. If the market is likely to be large and the firm owning the IP has the capacity to take advantage of the business opportunity, then the IP will have a value that far exceeds its reproduction costs.

But opportunity aside, startup risk for most early stage firms is very great, and while IP can mitigate this risk profile to some degree, the inability of a startup to exploit its IP will more than likely reduce its value to both the owners and potential acquirers.  One has no idea when sales will occur and how large they will be for firms that own IP but have limited or no sales history.  In these instances, any value attributed the IP will be uncertain and highly suspect.  Since IP values are in part determined by what a hypothetical licensee might pay in the form of a royalty rate, any selected rate—like expected sales—is subject to a great deal of uncertainty particularly where the IP is unproven.

But what if we knew what the range of sales would likely be in any future year and we also knew what the range of royalty rates might be? Knowing this, we could produce thousands of IP values based on randomly combining sales and royalty rates and arranging these in such a way that we form a distribution which shows the percentage of the total associated with each value.  These percentages are probabilities associated with each of the values produced.  The value of the IP is the sum of the product of each value multiplied by its associated probability. The beauty of this approach is that it does not require revenue projections which are notoriously optimistic and generally wrong both in terms of timing and size.  Below we report the results of employing this method to valuing IP of a startup firm with small first year sales.

 Case Study

Axiom’s client capitalized the costs of acquired technology, knowhow, trade secrets and identifiable costs incurred to develop, file, and defend the company’s patents and new patents or provisional patent applications. This knowledge base allowed the firm to produce proprietary chemical products that eliminated harmful microbes in a variety of customer settings.

Axiom undertook a comprehensive FASB 142 Step 1 analysis of the assumptions made by management which is the basis of its baseline forecast. This included a review of source-based market analysis undertaken by management and its consultants. In addition, we tested to see whether the number of customers implied by their projections is reasonable in light of recent developments at the company. Management has also provided details on its sales pipeline as substantive backup to its projections.

Based on this analysis we concluded that the IP may be impaired and that a determination of the fair value of the IP is required.  Since the firm had relatively little revenue and projections were generally unreliable, we used a Monte Carlo approach which required the following information:

  1. Current annual revenue
  2. Revenue growth range for each projected year over the eleven year economic life of the IP
  3. Range of royalty rates
  4. Cost of capital

The only input that is problematic in this analysis is item two above.  Axiom developed a unique data set which shows revenue growth rates for startup firms by industry for each year after each firm’s formation.  This data set was the basis for revenue growth ranges used in the Monte Carlo.  The essential characteristic of startup firm performance is that revenue growth could be 300% in one year and zero or even negative in the next.  For startups and early stage firms, revenue growth is essentially random and the Monte Carlo framework can easily accommodate this randomness.

The range of royalty rates within an industry can be determined in a reasonably straightforward way since there is a great deal of data on royalty rates. In our case the range varied between 1% and 4% and the rate was randomly selected.  The analysis consisted of a Monte Carlo simulation that generated 1,000 random revenue growth rates over the 11 year asset life and 1,000 random royalty rates. These growth rates were applied to a starting revenue number which was then multiplied by a randomly generated royalty rate to calculate the royalty fee income. We then summed the present value of the after-tax royalty fee income and added back the implied tax amortization benefit to arrive at the fair value of IP for each of the 1,000 growth and royalty paths. The histogram of IP values is shown below:

Histogram of IP

 We used the histogram as the basis for determining the distribution that most accurately approximates the IP generating function.  Using this distribution, the probability weighted IP value was calculated. This value, $4,145,100, is the fair value of the IP.  The beauty of the Monte Carlo is that one can determine not only the expected value of the IP but the probability that the IP is within a certain range.  For example, the probability that the value of the IP is $12 million (1.2E+7) is about 1%, whereas the probability that the value of the IP is $3.2 million is 26%.

Roger Winsby Interviewed on the Importance of Business Valuations

On May 8, 2015, Axiom’s president, Roger Winsby did a radio show interview with Josh Patrick, president of Stage 2 Planning Partners. and a host on Exit Coach Radio Network & Podcast.  They discussed the various reasons why business owners should consider getting a valuation and what to look for as a business owner who is getting a valuation done. The interview can be found in the Axiom Library or on Exit Coach Radio.com

 

C Corp to S Corp Conversion

From February’s Axiom on Value

The Window to Elect S Corp Status for 2015 Closes March 15

Many business owners are completely focused on the day-to-day operation of their business.  For these owners, issues of ownership transition planning and optimal tax strategy at the owner’s exit are “nice to consider” but will be irrelevant if the company does not make it through next month’s payroll.  CPAs for these businesses try to educate their clients on the long-run implications of staying as a C corporation, the de facto structure when incorporating, but often run into a variant of “why bother? In the long run, we are all dead”.

The decision whether to elect S corporation is a complex one, and should only be done after reviewing with your advisors the pros and cons of both corporate structures.  However, we note that according to IRS statistics, most “small” businesses chose the S form at some point in their stage of development, so it is an issue worth serious consideration if the owner expects to sell the business, rather than close it down upon retirement.

 Major Difference in Taxes Paid in an Asset Sale between a C and S Corp

The primary reason to consider electing S corporation status is that there can be a significant difference in the taxes paid on the sale of a business in an asset transaction between an S corporation seller and a C corporation seller.  (If the buyer is willing to buy the corporate stock, then there may be little or no difference in taxes paid by sellers of a C or an S corporation).   In an asset transaction for a C corporation, the gains on tangible and intangible assets are taxed at the corporate capital gains rate, which is 35% at the federal level.  Then, when the corporation closes down, it will distribute the remaining cash as dividends, which in most cases are taxable at the individual level.  The effective tax rate can exceed 55% of the gain in the C corporation assets.

The asset sale of an S corporation after 10 years following the S election will be taxed at a much lower rate, since the capital gains are taxed at the individual capital gains rate, and there is no tax on distributions.

The 10 Year Window for the BIG Tax 

For companies that elect S corporation status, there is a 10 year window following the election when the C corporation tax structure will apply to the value created as a C corporation.  The IRS imposes a “Built-In Gain (BIG) tax on the gain in value of the company’s assets as of its conversion from C to S.  The gain in value over the value as a C corporation is taxed based on the S Corp rules.  Consequently, it is necessary to determine the value of the company and its tangible and intangible assets in their C status as of the conversion date.

If S Election is Made, a Business Valuation Should be Done

The valuation should be done using the conversion date as the effective date.  This valuation will be based on the financial statements of the business up to the conversion date, and on the outlook for the company as of the valuation date.

The valuation should determine the total fair market value of the business.  For larger companies, there should be an additional analysis to allocate the total asset value over specific tangible and intangible assets, in case there are sales of specific assets during the 10 year window.

This valuation will not be filed with the IRS upon its completion.  The valuation will stay with the corporation and its CPA for use in the tax calculations, if there is a sale of assets or the business during the 10 year window.  Having the valuation done just after the conversion date is the best way to maximize the rewards from building and operating a privately held business.

 S Corporation Basics (from IRS publications)

S Corporation Requirements

To qualify for S corporation status, the corporation must meet the following requirements:

– Be a domestic corporation
– Have only allowable shareholders
* May be individuals, certain trusts, and estates and
* May not be partnerships, corporations or non-resident alien shareholders
– Have no more than 100 shareholders
– Have only one class of stock
– Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

Steps to Elect S Status:

Complete and file Form 2553:  No more than two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year prior to the tax year the conversion is to take effect.

Is Investing in an Equity Tranche of a CLO Too Risky?

From November’s Axiom on Value:

By: Dr. Stanley Jay Feldman, Chairman, Axiom Valuation Solutions

John Roberts, Managing Director, Axiom Valuation Solutions

One of the more complicated investments to value is the lower end tranches of CLOs, collateralized loan obligations.  Axiom’s CLO model provides investors with accurate pricing of all CLO tranches including the equity tranche, which, as it turns out, is highly valuable in a low interest rate slow growth economic environment as we show below.

CLOs are an important part of the fixed income landscape primarily because they offer benefits that other structures do not.   CLOs offer investors an opportunity to invest in slices or tranches of the CLO that meet their particular risk appetites and yield objectives.  At the same time, CLOs contribute to a more liquid loan market since CLOs use the funds raised through issuance of securities (tranches) to fund the purchase of loans.  The basic CLO structure is shown below.

Basic CLO Structure

A CLO operates like any other business: It owns assets, in this case bank loans, and funds the purchase of these assets with debt and equity. The debt stack is made up of a series of securities (X thru C) that have priority claims on the cash flows generated by the assets.  Securities with the highest priority claims (X-A) are paid interest and principal first, and hence are rated highly, while those securities that are at the lower end of the debt stack (B-C) have a lower priority claim on the cash flows and as a result face the possibility that interest and principal will not be paid as expected.   The subordinated notes are equivalent to equity since it receives cash flow only after X thru C is paid. In cases where issuing firms default on their loans, promised cash flows  to all but the least risky tranches are at risk of not being fully paid.   Since the equity tranche only receives residual cash flow, its value in large measure is a function of the probabilities associated with loans in the CLO portfolio defaulting, dollar size of the defaults, size of the recovery value associated with defaults and the timing of these recovery payments.   

Using Axiom’s CLO model, the chart below shows the payment to equity under the base case and three default scenarios.   Keep in mind that even though there is a default, in most cases, a large percentage of the principal is subsequently recovered.  The analysis assumes a 70% recovery rate, which is the average recovery of principal for bank loans.  The recovery occurs subsequent to the default date.

Equity Payout at Different Default Rates

In this example, the par value for the equity tranche is $35,000,000.  In the base case scenario, the equity holder would receive over $60,000,000 for a six year investment period.  If, however, the default rate for the collateral loans was 1% per year (cumulative 6%), the equity holder would only receive $54,000,000.  At a 2% per year default rate, the equity holder would receive $47,000,000, and at a 5% per year default rate, the equity holder would receive less than par or about $28,000,000.

Based on the weighted average credit rating of the CLO loan portfolio, the cumulative six year default rate for six years is about 12% based on a recent S&P study on loan defaults.   Our analysis indicates that the equity tranche is reasonably well protected since even at a 2% annual default rate (12% cumulative), cumulative payments to the equity tranche exceed par value.

Valuing a Startup as an Exercise in Quantum Physics

It seems to be clear, therefore, that Born’s statistical interpretation of quantum theory is the only possible one. The wave function does not in any way describe a state which could be that of a single system; it relates rather to many systems, to an ‘ensemble of systems’ in the sense of statistical mechanics. (Albert Einstein, on Quantum Theory, 1936)

The value of a startup and the character of a wave function in quantum theory are similar in that neither is best described by one value but reflect an ensemble of values for which there is a central tendency. Valuing a startup business is not only difficult and complicated but there are many factors that more often than not lead to significant miscalculation.  What we know is that there is no valuation model that is designed to address the spectrum of risks, and of course opportunities, that characterize startups as a group.

Axiom works with startups all the time, and the valuation framework most often used is  discounted cash flow. The accompanying assumptions typically include a  rapid growth phase  to reflect the “market opportunity” and a very high cost of capital, to reflect the myriad of undefined risks expected to be encountered, which is then used to discount the expected super growth in free cash flow.  The values that result from using this approach may pass the proverbial “smell test” but given the undisclosed trajectories that a startup can take, it is virtually impossible for early stage investors to use the business plan valuation as  anything more than a hope and a prayer. On the other hand, early stage investors that are considering investing in the startup generally have a good idea of whether the business model makes sense and also whether the commercial market is large enough to support some level of activity that the startup represents.  With this in mind,  investors proceed by first giving the business plan valuation a significant haircut and then determine what percentage of the startup they need to own to produce the desired rate of return. The end result is that the entrepreneur gets some financial capital but at a very stiff price.

In order to properly value a startup  that will yield higher business values and financial terms from investors that are likely to be less oppressive, entrepreneurs need to recognize two fundamental factors. First, they need to transparently incorporate, but not limited to, the factors noted below.

  1. There are a multitude of risks, including not getting to market on time,  the product/service does not function as anticipated, operating expenses are greater than expected, and efficiencies of scale do not develop as anticipated (meaning that expense levels are far higher than anticipated and the investment required to sustain commercial viability is greater than expected).
  2. Sales may be greater or less than expected and customer segments may not be as receptive as originally thought, while others may be more receptive but in order to take advantage of these developments costly modifications of the product or service are required.

Second, and most importantly, entrepreneurs need to understand that the factors noted above, along with others, will likely combine in unexpected ways that will lead to sales and expense trajectories that the entrepreneur has not anticipated but will nevertheless be expected to cope with. Each of these outcomes is associated with a different business value which means that a startup is really not characterized by one value- the business plan value- but rather a distribution of values which reflect the market place the business will develop in.

The question then becomes how do these factors combine? Is there a logic that may provide guidance?  For startups, more so then for established firms, there are many more known unknowns and this along with the plethora of unknown unknowns makes placing a final and precise value on a startup almost an exercise in futility.  However, all hope is not lost once we are willing accept the view that we do not know what trajectory the startup will take and certainly we generally know almost nothing about when the startup will become commercially viable.  If we consider the various factors that govern a startup and assume they will randomly combine over a future time period, then we can study what the valuation implications of these combinations are.  If we randomly combined the factors described in 1 and 2 above, for example, what would this tell us?

First and foremost it would generate a distribution of firm values and the associated probabilities of achieving these values.  The strength of this analysis is not in simply understanding the valuation  implications if specific things go awry but rather what happens if some things go right and others  do not since inevitably this will be the case.  In the end, we do not really know how future values of various valuation drivers  might combine in ways that may be detrimental to the startup or enhance its prospects. What we do know is that there are series of events that could occur and we want to know how these in combination will impact the prospects of the startup and its value.

The Exhibit below is constructed based on 27,000 valuations which are produced by randomly combining the multitude of paths that numerous variables that drive valuation can take. The startup is an Axiom client selling its unique products and related services to an energy-related business client base.

Probability Density Function

The founder was in the midst of his first capital raise and was receiving feedback that the value he placed on the firm was too high.  Given this feedback and accompanying term sheets that were hard to fully come to grips with, he turned to Axiom for help to better understand what the value of the firm really is and how to use what he learned to negotiate terms that are more consistent with the firm’s central tendency value.

There are two vertical lines indicating the value assigned by the entrepreneur in the business plan and the value implied by a VC investor group’s term sheet.   Based on Axiom’s analysis, the central tendency of the firm’s value distribution is in the neighborhood of $12 million.

So what is the value of this startup?   The answer is the value is likely to be between $10.5 and $13.6 million since this range covers a significant portion of the value distribution.   The eventual transaction value is based on a multitude of factors but two that are critical are:  level of investor competition and liquidity in the market for startups.

From October’s Axiom on Value

A Research Note on the Value and Under Pricing of Life Policies

By: Dr. Stanley Jay Feldman, Chairman, Axiom Valuation Solutions

John Roberts, Managing Director, Axiom Valuation Solutions

As the leading age of the baby boom approaches 70, we can expect this cohort to not only seriously evaluate their wealth positions and income requirements to maintain their desired life styles, they will almost certainly scrutinize all living expenses, including expenditures on life insurance premiums, to determine whether expected benefits are sufficient to rationalize the expenditures made.  While life products are often an important part of estate planning strategies, financial circumstances may be such that the insured no longer need the policy or the insured’s wealth position is such that the “instant estate” that a policy offers is no longer necessary.  In other cases, unforeseen expenditures such as family health expenses may result in the insured no longer being able to make the premium payments and thus may seek the liquidity that a life policy may have. Under these circumstances, the insured has three options: They are:

  1. Surrender the policy. For a life policy with a cash build up, the insured can surrender the policy and receive the net surrender value (cash value less borrowing less surrender costs as determined by the insurance company issuing the policy).
  2. Sell the policy in the life settlement market.
  3. Transfer the policy to a non-for-profit entity and take a charitable contribution (against taxable income) up to 30% of the life policy’s fair market value.

While the insured will receive a cash payment under option 1 if the net surrender value is greater than zero, it may not be the optimal choice particularly where the insured is north of 70 and in poor health.  In this circumstance, the insured will almost certainly be better off pursuing option 2.  Option 3 will be preferred to option 1 and perhaps option 2 if the charity is willing to accept the life policy and the donor’s taxable income is high enough so that he/she can take advantage of the potential tax benefit.   This outcome of course depends on the value assigned to the life policy. The typical solution up to this point is to “solicit bids” from the life settlement market (LSM).  But these prices are generally well below fair market value which we demonstrate below.

 The Under Pricing of Life Policies in the Life Settlement Market

The LSM developed from viaticals, the sale of life insurance policies held on AIDS patients. The limited life expectancies of the insured persons made the purchase of their policies an attractive proposition for both investors and the insured persons which used the proceeds of a sale to finance medical costs. The introduction of retro-virals and related measures significantly increased the survivability of AIDS patients, effectively closing the viatical market. Life settlements apply the viaticals’ concepts to seniors, predominantly those with impaired life expectancies.

Market Valuation: The secondary market potential in life insurance policies was projected by Conning Research to range between $156 billion and $192 billion in face value for 2013 through 2022 for an average gross market potential of $170 b

illion. Investors purchased approximately $2 billion worth of U.S. life insurance face values in 2012. This level is expected to continue, particularly given current economic conditions.

Prices offered by LSM investors reflect the fact that insureds often have limited options on the one hand and large cash needs on the other which result in LSM bid prices being lower than fair market value of transacted life policies.   As a result, investors earn significant double digit returns that are far in excess of their costs of financing and well above returns earned on diversified portfolios of publicly traded stock and fixed income securities.  While it is true that during the financial crisis life settlement investment returns suffered (see the chart below)[1], this result was predominately driven by a withdrawal of liquidity from the LSM and not a systematic failure of insurance firms’ ability to fund payouts.  Hence, the basic economics underlying the LSM did not fundamentally change.

LS IRR

Why Life Settlement Returns to Investors are Too High and Life Settlement Payouts to the Insured are Too Low

The chart above indicates that life settlement IRRs are typically in the double digits at least through 2011.  The chart below shows life settlement excess returns (IRR less the Treasury yield).

LS IRR Adjusted

In addition to posting significant positive returns, the life settlement asset class has a low correlation with portfolios of publicly traded securities. This means that it has important diversification characteristics and as a result, a low market risk premium (expected excess return based on risk).  We have estimated the long-term expected excess return on life settlement investments to be in the neighborhood of 2%.[2] The chart above shows that returns in excess of the 2% are positive and large.  Returns in excess of the market risk premium on the life settlement asset class are referred to as abnormal returns.  Large abnormal returns are generally not sustainable because competitive pressures bid returns down and prices up. However, life settlement investments are highly illiquid and part of this abnormal return could result from the fact that investors require an incremental return to compensate them for the illiquid nature of the asset class.

Based on research completed by Axiom Valuation Solutions on liquidity adjusted returns on syndicated loans[3], it appears that liquidity driven expected incremental returns are likely to be in the neighborhood of 3% for illiquid fixed income assets.   The chart below subtracts a 3% liquidity premium from the life settlement returns to derive the liquidity adjusted abnormal return.

LS Abnormal Returns

After adjusting life settlement returns for illiquidity, it appears that life settlement investments still generate sizeable abnormal returns.  There are a number of reasons for this but the essential driving force is the fact that the LSM is an asymmetric market where the sellers have limited information as to what their policies are really worth.  This results in the LSM underpricing life policies and the insureds often receiving far less than the policy is actually worth.

The data in the charts above are only through 2011.  To test whether underpricing is a characteristic of the LSM currently, we calculated the IRR on three policies valued by Axiom Valuation Solutions using the highest bid price from the LSM.  The results are shown below.

IRR for 3 Policies

In each case the price shown is the best bid offered by an LSM intermediary grossed up by 15% which reflects payments made to various parties that are involved in facilitating a typical LSM transaction.  The IRR shown reflects the policy purchase price and the premium payments the acquirer is committed to making based on the probabilistic- based life expectancy of the seller. The cost of capital reflects the financing cost based on how a typical LSM investor is expected to finance these life settlement investments.  It is clear that each policy’s IRR  is far greater than the cost of financing the life settlement investment. Like the historical data referenced earlier, these IRRs are also consistent with large abnormal returns.   Abnormal returns on financial instruments should not persist for extended periods of time since there are no inherent barriers to entry either based on technology and/or regulation.  This is certainly the case in the life settlement market.  To appreciate the implications of abnormal return persistence, the chart below compares the fair market value of each policy with its respective grossed up LSM bid price.

Value for 3 Policies

These results indicate that fair market value of each policy is twice the grossed up life settlement bid price. This underpricing is even more significant when one considers that the seller in each case receives less than the value shown on the chart. In short, these results strongly support the conclusion that LSM sellers are transferring abnormal incremental value to investors and as a result the latter are earning abnormally high returns while the former are receiving far less than their life insurance policies are worth.   While there are several factors contributing to this outcome, the predominant driving force is that the LSM is asymmetric and sellers are not fully informed about the value of their life policies.

Conclusion

The Life Settlement Market is an asymmetric market.  It allows informed investors to earn abnormal returns because insureds and their agents may not have sufficient information to evaluate bid prices.  If the LSM had a greater degree of transparency, LSM prices would be higher and better aligned with fair market value.

 

From September’s Axiom on Value


[1] Data from “Empirical Investigation of Life Settlements: The Secondary Market for Life Insurance Policies”, London Business School,  Afonso V. Januário and Narayan Y. Naik, January 10, 2014.

[2] The returns of the life settlement asset class have a low correlation with the returns from the public equity markets. This implies that its market risk premium (systematic risk) is lower than for a diversified portfolio of equities. Research by Axiom Valuation Solutions indicates the risk premium varies around 2% and therefore we use this value here for comparison purposes only.

Business Valuation 101: The Five Myths of Valuing a Private Business

From May’s Axiom on Value:

As you work tirelessly to meet the everyday challenges of running your own business, you may wonder why you should be interested in a column on valuing your business. After all, valuation is something you will be concerned about some time in the future when there is “need” for a valuation. If you feel like this and you stop reading, you will be missing an opportunity to insure that your business will survive and prosper.

Understanding the factors that determine the value of any business will pay tangible dividends by focusing you on ways to increase your firm’s short and long-run profitability. Moreover, if you choose to sell your business at some point in the future, this knowledge will assist you in positioning your company to receive the highest price. Therefore, there is no time like the present to begin to understand what a business valuation is, under what circumstances a valuation is customarily completed, and the critical issues to watch out for when events dictate that you undertake a business valuation.

What is a Business Valuation?

We first turn to the central issue—What is a business valuation? To answer this question, consider the following example. You own IBM stock and you want to know how much it is worth. Well, all you have to do is pick up the business section of the daily newspaper or go to any financial website, locate the stock tables and multiply IBM’s closing price by the number of shares you own. Through this simple exercise, you have valued your IBM shares or what you would receive in cash if you sold your shares at the closing price.

In concept, valuing your private business is the same as valuing IBM stock. But, because your firm is private, there is no stock table that you can conveniently turn to. No need to worry, however, because there is a pseudo-science, or some say an art form, that provides the foundation for skilled business appraisers to estimate what your business is worth. The problem is that the valuation process is often viewed as a “black box.” As a result, a whole mythology has grown up around valuation of private businesses. To help de-mystify the valuation process, let me introduce you to my top five myths about valuing a private business and explain how to avoid the pitfalls these myths present.

Top 5 Business Valuation Myths

Myth 1: Valuing a private business should only be done when the business is ready to be sold or a lender requires a valuation as part of its due diligence process.

Although the business sales and lending processes generally require that valuations be completed, if these events represent the first time an owner has a valuation completed, then you can be sure critical business and estate planning issues have not been addressed. If the business is to have a life beyond that of its current owners, then effective planning for ownership transition requires a regular valuation of the business.

Ownership transition may include gifting some percentage of ownership shares to family members during the owner’s life, thus reducing any tax on the owner’s estate at death. If a firm has several owners, a buy-sell agreement with accompanying life insurance should be in place so that if an owner dies, the remaining owners have sufficient funds to purchase the deceased owner’s interest at an agreed upon value. The buy-out value under these agreements should be updated regularly to reflect the firm’s financial progress over time and the valuation approach used should be one of several acceptable to the IRS.

Myth 2: Businesses in my industry always sell for two times annual revenue (the revenue multiple). So why should I pay someone to value my business?

The short answer is that data on selling prices indicate that revenue multiples within an industry are generally all over the lot. These rules of thumb used by business brokers, the individuals who often facilitate private business transactions, are median multiple values. The median value indicates that half of the revenue multiples are below the median value and half are above. Thus, the median value is just a convenient midpoint and does not represent the revenue multiple for any actual transaction. Unless the firm that is being valued is truly a median firm, then using the industry rule of thumb for this purpose is clearly wrong.

For example, according to a well- known source for business transaction data, Pratt’s Stats, recent revenue multiples for firms in the auto parts industry ranged from a low of .98 to a high of 8.3 with a median of 2.9. If you were valuing your firm for sale and your annual revenue were $100,000, then the value of your business could be as low as $98,000, as high as $830,000, or somewhere in between. Where your firm lies along this continuum is obviously of the utmost importance and can only be determined by a valuation approach that incorporates academically validated methods with industry-specific valuation factors. Myth 4 below discusses the legal and tax implications of assigning a value to your firm that is outside a permissible range.

Myth 3: A local competitor sold his business for three times revenue six months ago. My business is worth at least this much!

Maybe yes and maybe no. What happened six months ago is not really relevant to what something is worth today. What your business is worth today depends on three factors: 1) how much cash it generates today; 2) expected growth in cash in the foreseeable future; and 3) the return buyers require on their investment in your business. First of all, unless your firm’s cash flows and growth prospects are very similar to the competitor firm, that firm’s revenue multiple is irrelevant to valuing your firm. Moreover, without getting into the nuances of finance, even if the competitor firm was equivalent to yours in every respect and both firms were sold today, if interest rates were higher today than 6 months ago, the firms would likely sell for less than three times revenue. Conversely, if rates were lower today than six months ago, the firms may be worth more than three times revenue. In short, the value of your business, like the value of IBM stock, is likely different today than six months ago because economic conditions have changed.

Myth 4: How much a business is worth depends on what the valuation is used for!

The value of a business is its fair market value (FMV). According to the Internal Revenue Service, the FMV is what a willing buyer will pay a willing seller when each is fully informed and under no pressure to act. While there may be a FMV range, the wider the assigned valuation range is, the less reliable is the valuation and the more likely it becomes that the valuation will face greater scrutiny from potential buyers or the IRS.

Consider the example of a parent selling a business to a child. The incentives to assign a low valuation under these circumstances are significant. Given that the parent pays taxes on the difference between the value of the stock sold to the child and its value on the firm’s books (book value equity), establishing a low value on the firm’s stock results in the parent minimizing the capital gains tax owed to the IRS. The child, on the other hand, has to come up with less money, because the sales price of the business is much lower than its FMV. These types of transactions are common and the IRS is always looking for abuses. Alternatively, an owner of a business may make a charitable contribution of company stock. In this case, there is a significant incentive to place the highest possible value on the donated shares, because this will result in the largest charitable tax deduction. If the value of the donated shares is outside the FMV range, an IRS audit may well be in the donor’s future.

Myth 5: Your business loses money, so it is not worth much.

Most private businesses appear to lose money. Appearances, however, are often misleading. Not long ago, a friend of mine was considering buying an auto parts business in California. The asking price was approximately $950,000 and, according to the firm’s tax return, it hardly made a profit. Like many businesses of this type, this business was generating a great deal of cash, but this cash was masquerading as legitimate expenses. One expense category really stood out—payments to officers. This payment included the owner’s wage of $80,000 per year and a bonus of $150,000 that the owner paid himself at the end of year. The $80,000 wage is what the business would have to pay a stranger to do the same job as the owner. This was a real expense. The $150,000, on the other hand, represents what finance people call a return to capital. It is the cash the business generated and it is this cash that determines the value of the business.

Unlike public companies, the separation between ownership and management does not really exist in a private firm. Thus owners have some discretion over how they categorize cash flow generated by the business. Quantifying the size of these discretionary expenses is often a critical determinant of the firm’s value. As such, owners should keep a tab on what these discretionary expenses may be so that, when they are ready to sell the business, they can document these facts to the buyer. By doing so, the seller increases the buyer’s confidence that the business does legitimately generate the cash the seller claims and, accordingly, increases the buyer’s willingness to pay the asking price for the business.

In the final analysis, there are many important reasons that business owners should know the value of their businesses long before they decided to sell. By understanding the basics outlined above, you should be able to successfully plan the financial future of you and your family by understanding the value of your most important asset—your business.

Maximizing the Rate of Return on Your Next Acquisition: Why the Allocation of the Purchase Price Should Be Done Before the Deal Closes

From April’s Axiom on Value:

When an acquisition (stock or asset deal) is completed, the purchase price needs to be allocated to the assets purchased.  In our experience, the allocation exercise is typically done after the deal is completed.  A typical allocation table is shown below.

axiom on value1

Notice that in this case the portion that is goodwill is quite large at about 30%. From a post-acquisition perspective the tax benefit (assuming an asset deal or a stock deal with a 338 election) associated with goodwill is no different than the tax benefit associated with the customer list, for example- one fifteenth is amortized for tax purposes. Hence, the usual view is that the allocation of purchase price between purchased intangible assets and goodwill has no cash flow implications. This is often not the case.

Here is the reason. Goodwill is the value the buyer expects to produce in excess of what could be produced by the assets alone. Now in most cases goodwill can be divided into two components. The first is seller goodwill or goodwill that the seller would be expected to produce if the business remained on is historical trajectory. This goodwill includes but is not limited to additions to the customer base for example and/or strategies designed to reduce historical customer loss rates. What the buyer should not pay for is buyer goodwill. Following the example used here, buyer goodwill would equate to additions to the customer base above what the selling entity would be expected to generate on its own. Hence, the minimum purchase price should include the standalone value of the assets purchased plus seller goodwill. Any increment in the purchase price above this level gives rise to buyer goodwill. While competitive conditions and capital availability may result in a market participant paying up, the only way to know the potential extent of the over-payment is to conduct an allocation of the expected purchase price to the assets purchased.

On August 1st, 2014, Voltaire Advisors released the first “Valuation Risk Handbook”:

 Axiom Valuation Solutions is proud to be included in the directory of the first annual edition of Voltaire Advisors’ new handbook. Voltaire Advisors has sought a way to shed light upon some of the issues that firms today are dealing with.  Valuation issues are becoming increasingly complex and central to financial reporting for many organizations.  As the complexity has increased for these organizations, issues have also arisen for the valuation firms:

The Voltaire Advisors Valuation Risk Handbook aims to present, in one easily accessible publication, a clear and comprehensive review of the key issues currently facing firms involved in the ongoing valuation of financial instruments, and the sources of pricing, data and models available to them to assist their efforts. Nowhere previously has this information been collated in one volume, and we firmly believe that our Handbook will become an indispensable resource for valuations professionals.

(Excerpted from Valuation Risk Handbook, 2014)

 To download the FREE handbook and directory, click here: www.voltaireadvisors.com

Valuation Risk Handbook