Dave Cain: Welcome to unsuitable on Rea Radio, the award winning financial services and business advisory podcast that challenges your old school business practices and the traditional business suit culture. Our guests are industry professionals and experts who will challenge you to think beyond the suit and tie while offering you meaningful modern solutions to help you enhance your company’s growth. I’m your host, Dave Cain. On today’s topic, we’re going to undergo a bit of a refresher course on the topic of business valuations. Back to the basics, if you will. Mary Beth Kester, Rea’s director of business valuation and transaction Service is here to walk us through the basics like what valuation is, why business owners need one and what other valuable services valuation helps to support. She’s going to share some real life examples. Welcome back to unsuitable, Mary Beth.
Mary Beth Koester: Thank you Dave.
Dave: Hey, thanks for being my voice today.
Mary Beth: You’re welcome. I’m sorry, you don’t have one.
Dave: Oh, well you know there’s a lot in the office that say thank goodness he can’t talk today so …
Mary Beth: I don’t believe it.
Dave: So, you know, let’s talk about what’s going on at Rea and associates with the business valuation group. Lots going on.
Mary Beth: Lots going on. 2018 was a very busy year for us. A lot of growth, team expansion. Got a couple of great new hires on our team to help build out the service offering. And I’ll tell you what, Mike and Chris just hit the ground running. So it’s been fun and it’s been exciting.
Dave: So you guys are expanding and rock and rolling?
Mary Beth: Yes, we are.
Dave: Good. What’s the 2019 docket look like as far as business valuations, pretty strong?
Mary Beth: Pretty strong. It’s hard to believe that by the end of next month, first quarter at Rea’s, first quarter is already in the books. And we’ve had quite a busy backlog pipeline of projects and engagements, a lot of different engagements. So it’s been keeping the group busy and it’s been great.
Dave: Wow you guys already made your budget for the first quarter. That’s pretty early. You need an incentivize the group. You know, if you listened to some of our back episodes on unsuitable, there’s some great information about incentive compensation.
Mary Beth: Really?
Dave: Yeah, we had a really neat group and from Charlotte, North Carolina and a couple of episodes, take a listen to them.
Mary Beth: I’ll definitely have to check that out. And I wonder if they touched on anything related to timely excellence bonuses or new business incentive programs. Was that any of the?
Dave: Oh they did, and double bonus, I signed up for that …
Mary Beth: On double bonus?
Dave: On double bonus. Yeah.
Mary Beth: Okay. I like the sounds of that too.
Dave: Yeah, that sounds pretty good. But, so Rea is expanding across the state of Ohio, business valuations, etc. You know, let’s talk about, in 2019, the landscape as a business owner, why should I get a business valuation? What are some reasons outside the normal, hey, I want to maybe sell, what are things we can talk about?
Mary Beth: Sure. So I think the initial idea of why a business owner might have valuation done is for a liquidity event, some type of triggering event, whether that be, one of the partners passes away, and so we need to do valuation for probate purposes. Could be for estate planning or they want to gift a part or all of the company to the next generation of business owners. A divorce or partnership dissolution. All of those reasons would be a triggering event for why you might get your company valued. But we also see a lot of business owners now more than ever doing valuation simply for good business strategy and planning for the future. So starting that transition plan now getting the pieces in place to start building out their succession plan for maybe three, five, ten years down the road.
Dave: You know, kind of establish the foundation or the base level.
Mary Beth: Exactly. And that’s the entire purpose Dave, is setting that baseline and having a starting point, that we can then put plans into motion today to get them to where they want to be when they are ready to transition or when that liquidity event happens.
Dave: Could valuation for example, could valuation be used to establish a phantom stock program?
Mary Beth: It could, yes it could.
Dave: As maybe an incentive?
Mary Beth: An incentive program. It could be used for setting up shareholder or employee contracts and agreements, buy sells. All of those things.
Dave: You know, towards the end of December and certainly through January we saw the stock market going up and down. What impact does that have on valuations, if any, of the closely held market?
Mary Beth: Well, the activity in the stock market that from a public standpoint, when we’re looking at a market approach of companies, that does play a role in terms of where in the range of value, when you hear a multiple of EBITDA or multiplier revenue, what’s happening in the national economic environment does impact transactions and what we’re seeing in terms of M&A activity. What we tell business owners is it’s really difficult to try to perfectly time the sale of their company. So to try to play it in terms of what’s happening in the stock market is not really a good business strategy. Just getting all the pieces that you can get in place now is the best way to prepare yourself for that future event.
Dave: You know, it’s just one of many indicators to look at.
Mary Beth: It is, it is.
Dave: You know, maybe a snapshot of volatility. Don’t know.
Mary Beth: That’s right.
Dave: So, you know, I hear the term, your groups tossing around this, quality of earnings.
Mary Beth: Yes.
Dave: What’s going on there?
Mary Beth: The quality of earnings, the Q of E engagement. So again, I think this is not, this is not new news, but a lot of the baby boomer generation, they are planning, they’re planning their exits and their transition plans and part of that planning is having due diligence performed on the company. So whether a strategic or private equity firms coming in and potentially acquiring the company, what they’ll do as part of the due diligence process is request or require quality of earnings. And Dave, essentially what that is is it’s looking not only back at the historical earnings and cash flows of the company and really digging into the details of are those truly the earnings that the company achieved and are there any kind of normalizing adjustments we might need to make. But then looking at the forecasted earnings of the company going forward and making sure that those are actually achievable.
Dave: So if I’m running my fast car and my country club dues through the business, there’ll be an adjustment?
Mary Beth: Yeah. So if you’re treating your business, like a lifestyle business where you’re funneling things like your country club dues and your vacations and your personal airplane, and all the expenses for the family through it, then yes, there will be probably more adjustments needed on a company like that versus a non lifestyle type company.
Dave: You know, let’s talk about that a minute. I mean, I mean there are a lot of businesses do that and it’s okay, there’s some tax ramifications, but you know, we need to a wave of caution in the wind that that could impact value.
Mary Beth: It does. We’re working with a couple of clients right now actually, we’re doing a Q of E for a client who is either going to sell the company and set up an ESOP or just by the partner outright and then continue going forward. And so through the process of doing the Q of E and asking all of the questions that we had after we perform the financial analysis, what the conversation led to was, wow, there’s several hundred of thousand dollars worth of owner expenses that we’re adding back, and we need justification for those expenses. And a lot of the conversation revolved around while from a strategizing standpoint, that’s why we put everything through the books. We want to minimize our net income, our taxable income and I understand that. But the challenge with that is that really doesn’t set them up in a good place now that they’re ready to sell the company, they’re going to receive a lot more questions from the financing institution and a lot more questions during the ESOP process about those adjustments that we’re making because so much was funneled through.
Mary Beth: So this is something to consider.
Dave: Sure. Just one of many things, what kind of multipliers of EBITDA are you seeing out there?
Mary Beth: That really depends on the size of the company, Dave, the industry, potential buyer of the company and it’s just a range. It could be as low as two to three depending on the size of company and we’re seeing multiples of EBITDA but a upwards of seven to ten. Again, depending on the company.
Dave: Let’s say I’m a merging business, you know, I don’t have a lot of net worth, not a lot of value right now. Does your group offer to come in and help me build value? Does that make sense?
Mary Beth: Well, if you’re a startup company and you don’t have a lot of value today, but you are able to put together a detailed forecast of what the future operations, revenue and cash flows of the company will look like, absolutely. We can do a valuation for business planning and help that owner identify areas for growing value. Yeah, we can do that.
Dave: So again, maybe my business has a lot of intangibles. How does that fit into the valuation play?
Mary Beth: So expand a little bit on a lot of intangibles?
Dave: Well let’s say you have a lot of um, a trademark patents, a lot of work in that area, maybe some ideas, some intellectual property?
Mary Beth: So all of that plays into the goodwill value of the company, So when we’re valuing a company, we use three approaches to value. There’s the asset approach, the income approach and the market approach. And the income approach takes into consideration two key components of value. It’s the value of your fixed assets. So your furniture, fixtures, equipment, vehicles on hand in the company, and then the intangible values, you’re good will, your patents, your copyrights, your trademarks, non-competes or customer lists, all the things that build additional revenues and cash flows for the company above and beyond the fixed assets.
Dave: What about culture or brand effect? How does that affect quality of earnings or does it?
Mary Beth: It does. So again, that’s one of those intangibles. When we’re working on a valuation, we always interview management and really do a deep dive into the company, into the culture of the company, the management systems in place, the level of management depth, what is the culture like, what does the employee retention in the company like? Is there a high turnover? And if so, why is that? all of those things are important because when a potential investor is looking to acquire your company versus another company, having a workforce that’s intact and in place, a trained and skilled workforce, the type of culture that people want to come to work for and stay and build value in the company, it’s not just a clocking in and getting a paycheck type of an environment, but a place where people really feel valued. That does increase value. And you see that reflected in the bottom line numbers.
Dave: So even though it’s one of those things you know, it’s touchy feely, you can’t really measure it, but you as a experienced appraiser can go and you can kind of feel it and you feel better about your, conclusions?
Mary Beth: Sure. And we ask a lot of different questions and different types of ways to draw out that information from management. But what that does is it plays into our assessment of risk. And there are all these different kinds of qualitative factors that either add to or de-risk a company and that really impacts the value that we arrive at. It’s not just the cash flows and the growth projections, but it’s what type of risk is involved with this company and how are we managing or de-risking it.
Dave: Sure, sure. And again, let’s stay in that vein. What are other things that may decrease value? What are some things, you’ve talked about risk, but maybe some examples?
Mary Beth: So some examples of risk when we’re looking at a company, volatility of earnings is risky.
Mary Beth: When we see the revenues and the profitability having high peaks and low, low valleys year over year, when we’re looking at a trend of the historical financials, that’s risky. When we have a lot of employee turnover, that adds risk. When a company has a high concentration of customers or suppliers, let’s say one customer accounts for 50 or 60% of the company’s revenues, and that customer isn’t an a formal contract, that adds a layer of risk to that company if that customer where to go away. So we look at their product and their service lines. We look at customers and suppliers. We evaluate the competition of the company in the industry, depending on the area that they’re in. What kind of competition are they seeing, and what things are happening in the national environment and the economic environment that might be impacting that company. So different regulations coming down the pipe that might impact what they’re doing.
Dave: You know, we’ve talked a lot about on this podcast about the Wayfair a court case and you know, some companies have elected to follow that and some have elected to not follow it, which may have an unrecorded liability as a result of that. Would that also lead to if you know about that and is that a decrease in value?
Mary Beth: Yes, that does impact the valuation. That’s part of our standards, requires us to ask management about any pending or threatened litigation or lawsuits. So, absolutely.
Dave: So if a company has elected not to follow those particular rules, that’s certainly a red flag?
Mary Beth: It’s a red flag and it just creates a level of doubt. So again, when you’re evaluating a company, you have to think, put yourself in the buyer’s shoes. If I’m an interested buyer looking at this company, every time there’s something that creates a new red flag, that adds a level of risk and that ultimately decreases the value that that company has because it decreases its attractiveness.
Dave: So any kind of risk is one of the things that we have to be on the lookout as a business owner.
Mary Beth: Yes.
Dave: To avoid that risk. If you know, I’m thinking about taking he business to market?
Mary Beth: Yes. And another thing business owner wants to think about, especially if they’re thinking to take the company to market in the next couple of years, what does the preparation of your financial statements look like? A lot of the companies we work with, Dave don’t have audited financials. They’re typically lower middle market sized companies. So if you don’t have audited financials, do you have a reputable CPA firm or accountant that’s preparing monthly, quarterly financials and tax returns that are consistent year to year that are following gap. That’s really important.
Dave: So again, internally, the quality of that stuff, the quality of your accounting staff, it makes up a huge difference.
Mary Beth: It makes a huge difference.
Dave: So again, let’s, we talked about decrease and we’ve kind of scratched a little bit on increasing of value. Let’s talk about some real positive things that increase value?
Mary Beth: Some real positive things that increased value, well, let’s start with the obvious. When I look at a trend line of the last five years of historical financials and I see the hockey stick and a nice curve going straight up to the right that looks great both from a top line revenue standpoint, but even more so from the bottom line cash flow standpoint. So we want to see consistent, steady growth year over year, consistent financial statements, not a lot of adjustments that are needed to the financial. So, not a lot of normalizing adjustments. When we see a management team that is really ingrained in the company that’s very skilled. There’s layers and depth within management. There are controls in place, segregation of duties, a key workforce, an intact workforce with low turnover, processes and procedures that are in place in the company that are well documented. When there is diversified revenue lines, revenue streams in the company. So not a big concentration of customers. All of those things would increase the value of the company.
Dave: Sure. What about a type of entity? Does that have any bearing on the valuation of my business?
Mary Beth: It does, yes.
Dave: And you make adjustments accordingly, and how does that work, if I’ve got two businesses, side by side, one’s a C corp, one’s an S, try to balance that out and?
Mary Beth: Well it’s not a real clear cut. Here’s the impact on value, but it does come into play on the income approach when we’re tax affecting the earning stream.
Mary Beth: Yup.
Dave: And I would assume that would be owner’s comp type adjustments?
Mary Beth: And of course, so with, yes, with the owner’s comp, you always have to include a fair market value for owner’s compensation.
Dave: Okay. And again, as a business owner, we have owners that just like the zero at the profit through bonuses, you know, to maybe their, their management team, are those added back into the equation?
Mary Beth: Yeah. So any type of salaries and bonuses that would not be considered normal. So a normal replacement salary for somebody that works in the company, we would make those adjustments.
Dave: So normalized earnings, is that the term where we’re talking about?
Mary Beth: Yes.
Dave: Okay. Okay. What are businesses in your experience selling at a premium?
Mary Beth: Again, depending on the industry and depending on buyer. Right now, especially in Columbus and in Ohio in general, there’s been a lot of activity, a lot of transitions and transactions happening. So it’s, it’s prime time to sell your company. I can’t make a blanket statement and say that all companies are selling at a premium, but times are good right now.
Dave: Got more buyers than sellers, I suspect?
Mary Beth: There are, I get a few emails a week from PE firms with their qualifications of what kind of companies they’re looking to invest in. So there is a lot of private equity out there, a lot of money and a lot of capital that people are looking to invest
Dave: Any industries hotter than the other right now?
Mary Beth: Manufacturing construction’s pretty hot. Veterinary and dental both from a corporate consolidation standpoint, really hot. We’ve seen a lot there and the multiples we’re seeing in those two industries are mind blowing. Those would be the biggies right now, we’re going out with a couple companies and the tech space IT solutions and tech space area and those are pretty attractive companies as well.
Dave: Overall, just a real positive environment right now in the first quarter of 2019?
Mary Beth: It’s been really positive.
Mary Beth: I hope it keeps going.
Dave: Yeah, crystal ball, what’s it looking like as you guys look out and you think those valuations are going to hold?
Mary Beth: It depends on, so the question is, are we going to hit another massive recession? And if and when that happens, is it going to impact valuations of companies? Absolutely.
Mary Beth: It’s just hard to figure out the timing of that.
Dave: You know, you’d mentioned, a earlier part of the podcast about gifting, are there still minority discounts available?
Mary Beth: There are. So we do apply lack of marketability and lack of control discounts for minority gifts. Yes.
Dave: And gift tax returns still required to be filed?
Mary Beth: They are. So even though the gift exemption rate went up a lot, that will be sun setting in a few years here. So it’s actually, it’s a really great time to gift because the exemption limit has doubled. So …
Dave: And, that’s where another use of the valuation report, does that have to be attached to the gift tax return?
Mary Beth: It does. So if you’re going to make a gift and file a gift tax return, the IRS does require that you attach valuation. Now of course it’s always up to the owner what type of risk they’re willing to take. My caution there is even if you’re not going to have a taxable gift or a taxable estate, by attaching that valuation, you set the Statute of limitations for the IRS to come back and audit that gift return. And that statute is three years. If you do not attach a valuation, a certified valuation, then there is no statute of limitation, in ten, 15 years, you have the potential for the IRS to come back and audit that.
Dave: Come back and challenge that gift.
Mary Beth: Correct.
Dave: Especially if the rules change or there’s a sunset.
Mary Beth: That’s correct.
Dave: Okay, so again, that’s kind of important area often overlooked. If you’re going to do a gift, have to have some form of certified appraisal or valuation attached.
Mary Beth: That would be highly recommended if you’re risk averse or if you’re, you know, just trying to play by the rules. And honestly, it’s just a good method of protection.
Dave: Sure. Okay. I want a valuation. It’s just something that can’t happen in a week or ten days. I’m maybe my company’s not ready to be valued. What’s your recommendation to me?
Mary Beth: My recommendation, Dave is pick up the phone and call me or call one of my colleagues or send us an email and let’s have a conversation. It’s really important when we’re working with our clients to first understand why is it that they think they need or want a valuation. So what is the purpose and what’s really going on in the company? And once we gain some of that background story and that background information, we can better guide the business owner with making a decision for what to do now versus what we do later. Like I said in the beginning of our talk today, a valuation number one is step one in terms of any kind of good business strategy, succession planning, liquidity event, it sets the baseline for where you’re going to go with the company and ultimately figure out what your plan of action is and what the timing looks like.
Dave: Obviously you’re in the business of supplying business valuation services, but uh, what’s a good recommendation? Rule of thumb, how often should I have a business valuation? It’s not a once a year event is in. I don’t think it is, but …
Mary Beth: Actually we have a lot of clients who do get an updated valuation once a year.
Mary Beth: They do that as part of their management strategizing. So once you do a valuation the first time, what’s nice about that is if you are updating it annually, then there’s a lot less work that’s involved with getting the updated year after year, because we’re just adding one additional year of financial information and then they’ve always got an updated valuation of their company. Should something happen in that year.
Dave: Well you bring up a good point because, what’s the partnership agreement say? What’s the buy sell agreement say?
Mary Beth: Exactly. So getting that valuation done is, you could think of that as a trigger for them to reevaluate the partnership and the buy sell agreements.
Dave: Great. Great.
Mary Beth: Yeah.
Dave: Our guest today has been Mary Beth Kester, the director of Rea;s Business Valuation Services Across the state of Ohio. Thanks for joining us. Great job today.
Mary Beth: Thank you for having me, Dave.
Dave: Listeners, are you wondering what your business is actually worth and what you should do to get its value going? Wonder no longer, as Mary Beth said, give her a jingle, give her a call, shoot her an email. We’ll get you started. In the meantime, if you enjoyed today’s episode, let us know, like it, comment on it or share it and don’t forget to check out videos of our podcast on YouTube. Until next time, I’m Dave Cain encouraging you to loosen up your tie and think outside the box.
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