--Working ON your Business, not just IN your Business--

Understanding and Increasing Business Value

American Cheese SocietyJuly 30, 2016

TODAY’S AGENDA

• What really matters in business valuation?

• Is your business transferable?• Why every business has more than one value.• Can’t I just use an industry rule of thumb?• Why a company’s financial statements do not

indicate the value of the business.• How is a business valued?• How can value be increased?

But I’m Not Ready to Sell…

• Investment vs. Employment

• Identifying your successor is a fundamental objective

• Value can be increased if you have time and understand the drivers

In Madison:(608) 257-2757

Is the business actually a transferable entity, or is it a career with the

“tools of the trade”?

The Transferable Business Has Two Key Characteristics*

• The business is not dependent on a specific individual with skills or relationships that cannot be transferred.

• The business generates sufficient cash flow for BOTH market compensation and return on investment.

Is it Transferable?

vs.

Year 1 Year 15

What about……

Those handy rules of thumb?

•Multiple of Revenue?•Multiple of EBIT?•Multiple of EBITDA?

ABC Cheese v. XYZ Cheese4.35 x EBITDA

• ABC Company• High employee turnover• 26% of revenues from one

customer• No contracts for future work• Facilities at capacity• Contracts do not allow for

surcharges• New competitor just came

to town

• XYZ Company• Low-no employee turnover• 4% of revenues from one

customer• Contracts in place for future

work• Facilities at 60% of capacity• Contracts do allow for

surcharges• Competitive landscape

unchanged

Fair Market Value

The cash or cash-equivalent price at which the security would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.

Article 20.2031-1(b) of the Estate Tax Regulations and Revenue Ruling 59-60, 1959-1 C.B. 237

Prospect Ranking ChartBuyers of a Business Enterprise

Highest Enterprise Value9 Strategically Positioned Businesses8 Diversifying Businesses7 Competing Businesses6 ESOPs5 Outside Investors/Managers4 Insider Management Group3 Diversified Passive Investors2 Investor/Job Seeker1 Undiversified Passive Investors

Lowest Enterprise Value

Business Valuation Approaches

Income Approach

Market Approach

Asset Approach

Asset Approach• Determines value based on the current market

value of underlying assets

• Seldom used for operating companies

• Relied upon for real estate or investment holding companies

• May not be applicable if business is a going concern or minority interest is being valued

Balance Sheet Adjustment To RestatedAs Reported Market Value Balance Sheet

Cash 50,000$ 50,000$ Accounts Receivable 200,000 (25,000) 175,000 Inventory 450,000 (50,000) 400,000

Plant & Equipment 750,000 1,000,000 1,750,000

Land 250,000 1,000,000 1,250,000

TOTAL ASSETS 1,700,000 1,925,000 3,625,000

Accounts Payable 100,000 100,000

Interest-Bearing Debt 500,000 500,000

Built-In Capital Gain Tax 350,000 350,000 -

TOTAL LIABILITIES 600,000 950,000 -

NET EQUITY 1,100,000$ 1,575,000$ 2,675,000$

Asset Approach to ValueAsset Approach to Value

Market ApproachAre there any comparable transactions whose data we could apply to our subject company?

Guideline public companies

Comparable private transactions

Prior transactions in the subject company

Income Approach

Value today is the present value of future

economic benefits

Income ApproachTwo methods—

• Capitalization of earnings—only if future will look like most recent year(s)

• Discounted future cash flows—most detailed method for reflecting the specific company’s expected future

Income Approach

Capitalization of Earnings

• Involves a numerator• A single number intended to represent the future economic

benefit

• Involves a denominator• Represents the rate of return required by the investor

What’s the Problem?• Based solely on the income statement

• Past performance

• No allowance for future capital expenditures

• No allowance for future working capital needs

• Cash• Accounts Receivable• Inventory

• Capital Structure: relies on cost of equity only

GAAP Accounting Was Never Intended to Reflect Value

• GAAP accounting captures utilization of assets and capital at work

• Value is based on capacity, not utilization

• Accounting is backward looking• Value is forward looking

Analyzing the Business Enterprise

What’s Different?The DCF Method reflects the future business plan for the business:

• Models the business’s future expected performance

• More detailed cash flows• Allows for varying capital expenditures• Allows for varying working capital needs• Allows for cost of capital that includes debt

and equity (weighted average cost of capital)

Discounted Cash Flow ProjectionsProjections

Normalized Year 1 Year 2 Year 3

Base

Revenues $7,600,000 $8,512,000 $9,873,920 $9,478,963

12% 16% -4%

Cost of Goods Sold 6,080,000 6,809,600 7,899,136 7,583,171

Gross Profit 1,520,000 1,702,400 1,974,784 1,895,793

Operating ExpensesPayroll 760,000 775,200 790,704 866,518

Payroll Taxes 68,400 69,768 71,163 78,587

Rent 38,000 38,760 39,535 40,326

Utilities 12,000 12,240 12,485 12,734

Telephone 12,000 12,240 12,485 12,734

Professional Fees 34,000 34,680 35,374 36,081

Interest Expense 46,000 43,384 39,743 35,915

Depreciation 24,000 26,143 30,429 34,714

Total Operating Expenses 994,400 1,012,415 1,031,917 1,117,610

Net Operating Income $525,600 $689,985 $942,867 $778,183

EBITDA 595,600 759,512 1,013,038 848,812

Developing Equity Capitalization Rate

Risk Free Rate 4.00Equity Risk Premium 5.00Industry Risk Premium 4.20Size Premium 9.00Specific Company Risk 4.00Total Expected Return 26.20

Less long-term growth (3.00)

Capitalization Rate 23.20

The Conclusion: Discounted Cash Flow Projections

Projections

Year 1 Year 2 Year 3

Calculation of Cash FlowEBIT 733,369 982,610 814,098 Plus Depreciation 26,143 30,429 34,714 Change in Working Capital (58,200) (86,912) 25,204

Cash Flow from Operations 701,312 926,126 874,016

Capital Expenditures (46,000) (30,000) (30,000)

Cash Flow to Investors 655,312 896,126 844,016

Distribution for Taxes (263,296) (375,275) (302,351)Advantage of S Election 79,111 144,281 169,841

Cash Flow to Investors after Taxes 471,127 665,132 711,506

Weighted Average Cost of Capital 21.30%PV of 10 Years CF to Debt & Equity Investors 3,084,441 PV of Perpetuity 1,048,345 Total PV of Invested Capital 4,132,786 Less Interest Bearing Debt (900,000)

100% Equity Value $3,232,786

So Why Doesn’t…..

Value = Price???

Bargaining Position: The Fulcrum of Price*

• Value does not equal price• What is the motivation of the buyer?• What is the motivation of the seller?

How Can A Business Owner

IncreaseValue?

Think Like a Buyer…..

• Economic Risk—general economy and industry—it’s about timing

• Financial Risk—it’s about consistency• volatility of sales, gross profit & growth• predictable, recurring revenue• Access to capital• Quality of financial statements

Ways to Increase Value

• Financial Opportunity—focus on gross profit

• Asset Risk—age and condition—it’s about reinvestment

• Product Risk—diversification of product line; specialize v. generalist

Reduce Risk – Increase Value

• Market Risk—geographic diversification

• Technological Risk—life cycle

• Regulatory Risk—environmental and other reg.

Reduce Risk -- Increase Value

• Legal Risk—eliminate litigation exposure, product liability, employee discrimination

• Legal Audit: Corporate Records in Order—unsigned corporate documents; missing stock certificates

Reduce Dependencies• Customer Dependence—percentage of total

sales >10%

• Vendor Dependence—alternative suppliers

• Depth of Management—key person dependency

• Quality of Management—experience, education, vision, management skills, culture

It’s About the People

If a particular employee left, what could he or she take

that could damage the business?

It’s About the People…Prevention

• Employment Agreements

• Non-compete Agreements

• Develop functional depth

It’s About the People….Motivation

•Finding, Keeping and Motivating Key Employees

•Distinguishing between majority of employees and “key” employees

The Usual Employee

•Desires:•Pleasant work environment•Stimulating job•Good wages•Benefits•Job Security

The Key Employee•Wants More

• They think and act like you

• Eager to be given responsibilities and challenges

The Key Employee•Key Employee(s) Want

• Want to see the business grow and prosper and want to grow and prosper along with the business

• Take pride in being identified with and contributing to a successful business

Elements of Successful Incentive Program

1. Plan provides financially attractive awards to key employees

2. Plan is specific—determinable performance standards

3. The plan is structured to increase the company’s value

4. Incentive reward is vested-payment linked to tenure

5. Program must be thoroughly understood

Guard Ownership• Cash bonus plan may be sufficient incentive• Must have provisions to buy back the stock• Determine the mechanism for fixing the value

of stock in the event of repurchase• Minority owners have substantial rights• Is employee critical now and likely to be later

(or a hindrance later)?

“If you don’t know the value of your company, I’ll steal it from you and it will be ethical, legal and moral.

If you know the value of your company and can justify it, I’ll be perfectly happy to pay every nickel of it.”

--Warren Buffett

In Summary

•Know the value of your business

•Evaluate your business’s success based on increased value in your investment.

In Summary• Not all businesses are transferable

• Different buyers will pay different values for the same business

• A company’s financial statements do NOT reflect its’ value

• Rules of thumb are dumb—don’t use them

You’ve Got Questions We’ve Got Answers!

Cathy J. DurhamPresident

Capital Valuation Group, Inc.cdurham@capvalgroup.com

608-257-2757Website: www.capvalgroup.com