SOME THINGS TO LOOK FOR IN VALUATIONS OF THE FAMILY BUSINESS, IN SEPERATION AND DIVORCE

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1 SOME THINGS TO LOOK FOR IN VALUATIONS OF THE FAMILY BUSINESS, IN SEPERATION AND DIVORCE (Some rough notes on a few practical things to look for when reading a business valuation and some things that may not be apparent in the valuation) Simple Definition The entire value of a business; the summation of all its parts, tangible and intangible Source: The choice of method is often influenced by the purpose of the valuation e.g. refinance, listing for sale, valuation by person who wants to retain the business such as selling a share to buying out partners or determining a fair value of the family business in separation and divorce. Some common methods of valuing a business Market value What is the business worth to sell on the open market where you have a seller who wants to sell and a buyer who wants to buy the business and neither is under pressure? But what if the owner is not selling the business There can often be wide variations between the market value and the values you get from the other methods below. This can be demonstrated when valuing minority interests, particularly in Family owned businesses. If offered to the market, the value of the minority interest may be reduced as it may be hard to find a buyer who is prepared to buy the share.

2 On the other hand, if the business is being retained and being valued for Family Law proceedings, then it is arguable that the value is not affected as you are simply valuing a projected income stream top the minority owner. Net Asset All assets less all of liabilities of the business. Goodwill, may be thought of as, the extra someone will pay to buy the business over the value of net assets. Return on capital A prospective buyer would be interested in knowing what return the business is going to give them on their investment, compared with the option of not buying it, keeping their job and leaving their proposed purchase money earning interest in a secure investment? Eg. Assuming the following and leaving aside tax issues, here is a simple example. Say:- - you could earn a salary of $100,000 - current interest rates on term deposits are 5% - you have $1,000,000 to spend on the business and - you intend to work full time in the business after purchase. If you invested the money and kept working, you could receive a total income of $150,000 i.e. interest + wages. Therefore, the business would need to make a net profit of $150,000 or more, for you to receive more money from buying the business than leaving your money in the bank and continuing to work. Some people may be prepared to pay a premium for lifestyle businesses where they may earn less, but enjoy themselves more or have more flexability.

3 You may need to make additional adjustments to the value of the business to a purchaser where business provides additional benefits, like accommodation etc. Discounted Cash Flow - DCF' A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Calculated as: Also known as the Discounted Cash Flows Model. Read more: Sales/turnover Multipliers In some industries, the norm is to determine value by using a multiplier times the firm s annual sales. Consulting firms, radio stations, temp agencies, PR or ad agencies, professional practices, retailers and insurance brokers are often valued using a multiplier of annual sales.

4 The size of the multiplier depends on the exact type of business, the predictability of sales from year to year and many other factors. Generally, the industry multiplier is the starting point and is then adjusted based on specifics of the business where the business may compare favorably or unfavorably to the average business in a particular industry. Future maintainable earnings The Future Maintainable Earnings (FME) methodology is the most common method of valuing profitable businesses in Australia. The future maintainable earnings methodology is a derivation or simplification of the Discounted Cash Flow (DCF) method. Whilst the discounted cash flow methodology is considered to be superior in determining the value of a business, the information available in a small business is not sufficiently reliable or available for discounted cash flow models. We will concentrate on the Future Maintainable Earnings method for the rest of this paper. The focal point of this method is the net profit of the business. (I.e. Income less expenses) We need to pay close attention to what affects the profit of the business, both in the usual EBIT adjustments and Forensic checking of the figures in the financial statements.

5 E.B.I.T. adjustments Acronym for EARNINGS BEFORE INTEREST AND TAXES not to be confused with the other 2 definitions in Wikipedia - Electron Beam Ion Trap - a two-party quantum state with quantum entanglement and the fundamental unit of bitpartite entanglement The aim of the EBIT calculation is to adjust for the non business expenses of the owner and interest on the businesses borrowings that are included in the profit and loss statements, and to include real world figures where applicable for things such as the Market rate that would be paid to a manager who could do the job of the business owner. Examples of EBIT adjustments. Remove business owner/proprietor s personal expenses, such as - salary - car expenses - private components of say home office expenses, utilities, travel - wages paid to associated parties, or entities. Eg spouse, new girlfriend, children or other relatives on the payroll that are not true business expenses. - consultancy fess to associated entities. - Interest. - Taxes (Not dealt with in this talk). - Sometimes called EBITA as also adjusts for depreciation. (Discussed below) Add a market salary for the work done by the business owner. - Here we are trying to work out the true profitability of the business allowing for the real market cost of a manager.

6 Net profit for one year V - Net profit Averaged over several years V weighted averages of Net profit Usually the valuer will want to average the net profit over 3 to 5 years, depending on the circumstances. If the profit has been fluctuating or there has been an unusual spike or drop the profit in one year then they may take the average over the longer period. If there has been a strong upward trend in the profit of the business over several years and this is likely to continue, then they may use a weighted average such as this. - 10% from year 1-20% from year 2-70% from year 3 If the growth has been more gradual then may take over a longer period and less variation in the % between years e.g. - 10% from year 1-20% from year 2-30 % from year 3-40 % from year 4 Multipliers Once the valuer has worked out the profit figure to be used they will usually apply a multiplier to the adjusted/weighted net profit. Like the Sales/turnover Multipliers referred to above, this is highly influenced by many factors, such as the industry the business is in and the reliability of the client base to continue to generate income. Other things that may influence the choice of the multiplier might be - Industry averages - The reliance of the business on one owner - The reliance of the business on too few customers

7 - Likely changes (good or bad) to the industry The range is usually between 1 to 5 times the adjusted/weighted net profit. This is a subjective assessment by the valuer that can be assessed differently by different valuers. The choice of an appropriate multiplier is often one of the most contentious parts of the business valuation. E.G. Even though the business being valued may have an agreed adjusted/weighted net profit of say $100,000 per year, the value of the business if the extremes in the multipliers were used could range between $100,000 to $500,000 for the same business. Obviously, in a Family Law case, if the choice of a multiplier is too far off the mark, it would result in a significant windfall to the interests of one of the separating parties and loss to the other. Mixture of different methods Local Real Estate Agency valuations can illustrate that even the same business may need to have different parts of the business valued by different methods. The sales component of the Real Estate business usually has little value above the net assets plus maybe a small loading for the goodwill. If the business has been around for a long time and has a strong brand, or if it is part of a popular franchise that has granted it an exclusive and sought after area then the goodwill component may be greater. This is because most Real Estate agencies do not have an ongoing or reliable source of listings and have to compete to find each new listing. On the other hand, the rental part of the Agency will often be valued at between 2 and 4 times the turnover of the business. This is because - the rental management fees usually provide a steady and predictable income stream and

8 - there is a client base of landlords who are likely to buy and sell properties and provide business for the sales side of the Real Estate Agency. - This multiplier again may be influenced by the length of time the rent roll has been running and/or the average length of time the properties have been in the rent roll. Looking behind the figures used in the valuation. In most valuations you will see a disclaimer which effectively says that the valuer is taking the figures at face value as they are relying in the information provided to them in the financial reports etc. Sometimes a forensic investigation will show that there are inaccuracies in the figures shown in the Profit and loss statements and/or the information provided to the valuer by the owner for the EBIT adjustments. Professional Forensic investigators can be very costly and a cost/benefit analysis is important before engaging in a forensic investigation. This is particularly important in Family Law cases where there is not only the cost of the investigation itself, but also the additional cost of lawyers to analyse then argue over the findings of the investigations. The decision to engage a professional Forensic investigator or undertake your own forensic investigation will depend on the funds available and the extent to which you/your client believe there are inaccuracies in the Profit and loss statement. It is important to remember that as a result of the multipliers referred above every $1 adjustment made as a result of your forensic investigation may increase or decrease the ultimate value of the business by up to $5 depending on the multiplier. If acting for the person in Family Law proceedings, who is not retaining the business you are looking for items in the Profit and loss statement that understate the profit including those where the - Sales/revenue is understated.

9 - Expenses are overstated - The EBIT adjustments are not accurate. Examples of things to look for Sales understated. If the family business being valued is say, a coffee shop, then it would be helpful to check the number of bags of coffee being purchased per month. This can be done by making an enquiry of all the coffee suppliers to the business and then comparing this with the revenue from coffee sales. If the suppliers will not cooperate, then this information can be sought by subpoena. There are industry standards to show how many cups of coffee you can make from a bag of coffee and the price of each cup of coffee is known. You should be able to check if the coffee sales and the number of bags of coffee purchased tie in with each other or there are anomalies. If there seems to be too few sales it can mean several things including, - Sales not accounted for due cash in the pocket or too many freebies. - A growing stockpile of coffee (which you should be able to see increasing in the stock figure in the balance sheet each year) - It could also be a very bad Barrista who makes the coffee too strong or wastes the coffee. Another example of trying to check for understated income might where you are acting for the wife of a Concreter who takes payments from customers in cash or goods and does not put the job on the books. Again, you can consider an enquiry of or a subpoena to the concrete suppliers to the business, to provide the dates and addresses of all the deliveries made to the business over say 1 to 2 years. You would then compare these with all of the invoices for work done by the business over this period to see if concrete has been delivered to jobs or on dates that have not been invoiced by the business.

10 Examples of things to look for in the expenses - Bad debt write offs (May have been paid in cash and then written off) - Level of depreciation (As you can choose own level of depreciation with self assessment, you may find that the business has purchased machinery/equipment recently and decided to write it off over very short period. All other things being equal, this will make the business less profitable now, but much more profitable once the asset is no longer depreciated) - Exaggeration of wages or number of employees. (Claiming the expense of a wage for an employee that does not exist or who does not do the level of work claimed) - Third parties expenses included that are not actually related to the business. (Providing a car and paying for home and utility expenses for an employee where these are not really business related. E.g., husband provided, car, overseas travel and paid home utilities for his girlfriend who worked part time but also received a full time wage. - Compare expenses to industry averages for type of business. Examples of things to look for in information provided to valuer for preparation of EBIT calculation Market salary to replace owner. The owner who wants to retain the business may try to inflate the amount used for a market salary when doing the EBIT calculations to reduce the profit. You need to look at industry standards and published information. E.g. if the market salary is overstated by $50,000pa and a multiplier of 3 is used, then this will item alone could reduce the value of the business by $150,000. Owner claiming they would need to be replaced by 2 staff. E.g. Owner of nursing home claimed she did the job of a nurse and manager. The valuer was instructed to overstate the market adjustment by the wage of a fulltime nurse of $60,000 and the cost to replace her with a manager by a further $50,000 (total $110,000). Using a multiplier of 3, this alone would have resulted in the reduction of the value of the business by $330,000.

11 Not providing the valuer with the all private expenses paid on their behalf. Conclusion This is not intended to be an exhaustive or learned treatise on business valuations and Family Law, but rather some simple notes of some things to be aware of when considering the claimed value of a business.

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