For over 35 years Mr. Smith has owned and operated a profitable manufacturing company. He wants to sell his company and retire in the sun.
For the past 10 years Mr. Bell has been a competitor of Mr. Smith and is very interested in purchasing his company. Mr. Bell is no business novice so he knows that a competent business valuation of Mr. Smith’s company is the key to analyzing the price to pay for the company.
Our law firm has been involved in several transactions where the seller of a business over-stated the revenue, and/or under-stated the expenses of the company in an effort to secure the highest selling price. Consequently, the business valuation was not an accurate picture of what was represented to the buyer, and a lawsuit was filed. Prior due diligence could have prevented these legal entanglements.
Here are some suggestions our firm shares with clients to help them avoid paying too much for a business.
The value of a business interest is generally based on two things: (1) what the company owns, which is reflected on the balance sheet, and (2) what the company earns, which is reflected in the income statement.
Also the nature and history of the business being sold is important. Here we counsel our clients to consider the:
- Size and consistency of the growth rate
- Stability of the business or lack thereof
- Products, services and company assets
- Record of sales
- Management – especially recent changes
- Diversity of operations
Another factor in the due diligence process is the general economic outlook and condition of the particular industry in which the business operates. This directly affects how a business is valued. Common questions to be considered include the following:
- Is it a growth industry?
- How competitive is this company in the industry?
- What would be the economic effect of the loss of a key employee?
The book value of stock is another factor we tell our clients to note that when thinking about purchasing a company. Generally, that value is:
- Based on assets minus liabilities – to demonstrate its liquidity position.
- Believed to be unreliable in valuing most businesses.
The earning capacity of the selling company is perhaps the most significant factor.
- Earning capacity is average earnings over a five-year period multiplied by a capitalization rate
- There is no standard table of capitalization rates
- Capitalization rates are usually based on price-earnings ratios of similar, publicly-traded companies
Here, we suggest that our clients engage an expert to review all of this financial information. We assist our clients in finding an expert who is a good fit for their needs.
Another primary factor in these transactions is the dividend paying capacity
- This does not mean dividends actually paid, but the capacity to pay
- The IRS recognizes the need to retain a reasonable portion of the profits for expansion needs
No doubt that the selling company’s goodwill and other intangibles have a value. We factor that into the transaction, and inform our clients of the following:
- Goodwill is based on earning capacity. It represents an excess of net earnings over and above a fair return on the net tangible assets of the business;
- Other intangibles include the following;
- Ownership of a trade or brand name
- Prestige and renown of the business
- Prolonged successful operation in a particular locality
Our firm thinks that comparables need to be examined. For example:
- Prior sales may be meaningful if they were arms-length transactions
- Small isolated sales or distress sales are not significant
- Valuation of a controlling interest may carry a premium value
- Valuation of a minority interest should include a discount
How the selling business performs in comparison to its competitors is another consideration. For example, the valuation may consider the market price of stocks of similar, publicly-traded corporations.
- Companies must be sufficiently comparable
- The comparative appraisal method examines price-earnings, price-book value, and price-dividend ratios of each corporation
Some factors will carry more weight than others. There is no exact mathematical formula.
A study by Standard Research Consultants showed that in 74 tax cases the most frequently used factors were:
- Sale price, in 33 cases
- Book value, in 24 cases
- Earning power, in 17 cases
Earnings will typically have more importance in companies selling products and services, whereas net worth will be more important in real estate holding companies.
Even if the relevant companies are not publicly traded, but are “closely-held” companies the valuation of the selling company is critical.
As this brief summary demonstrates, due diligence is a sophisticated process. It requires experienced experts and, if done right, could spare you later a costly and time consuming lawsuit. We’re here to help you make a successful business acquisition or take legal action if required.
Mark A. Alexander
5080 Spectrum Suite 850
Addison, Texas 75001