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Factors affecting the value of a company

06.28.21

Read this if you are a business owner. 

Consider the value of the following two hypothetical companies. Roger owns Wag More, Bark Less (WMBL), a pet service company that employs 10 full-time dog walkers. Anita owns a very similar company, Happy Dog Walking Service (Happy Dog), which also happens to employ 10 full-time dog walkers. These companies are both almost identical, and last year, they generated the same amount of revenue and income. A key difference, however, is in the management styles of the owners. Roger is extremely disorganized and has difficulty with record retention, locating information, and tracking and analyzing data. He is relatively inexperienced as a manager. Anita, meanwhile, is very punctual and organized and has 15 years of management experience. She is very capable of monitoring dog-walking data to optimize routes, manage employee utilization, and track client satisfaction. Which company is more valuable? 

Despite being identical in terms of service offering and size, most people would identify Happy Dog as being more valuable. Alarm bells start to ring in a valuation analyst’s head when learning about the sloppy management style, lack of experience, and poor use of data at WMBL. The difference in value should be substantial. Despite generating the same amount of profit last year, Happy Dog could be worth twice as much as WMBL because these risk factors may jeopardize future profits.

In addition to the risk factors from the above example, there are many other drivers of business value.

Valuation formula

In its simplest form, the valuation of a business can be reduced to the following formula based on earnings before interest, taxes, depreciation, and amortization (EBITDA). Factors that affect value do so by affecting the valuation multiple. Companies such as WMBL would be worth a lower multiple of EBITDA, and a higher multiple would be justified for less risky companies such as Happy Dog. 

Estimating an EBITDA multiple

A generic multiple often thrown around is 5x EBITDA. EBITDA multiples from the DealStats database show a slightly lower average over time. From 2017 to 2019, the EBITDA multiples were around 5x, then declined in 2020 and 2021. The chart below shows trends in historical EBITDA multiples.1 

Median Selling Price/EBITDA with Trailing Three-Quarter Average


In reality, EBITDA multiples vary widely by industry. For example, in the DealStats database, the median EBITDA multiple for retail trade was 3.8x compared to 6.5x for manufacturing companies.2 The chart below presents EBITDA multiples by industry from the DealStats database.

Selling Price/EBITDA Interquartile Range by Industry Sector (Private Targets)


Even within a specific industry, multiples can vary dramatically. For example, from the chart above, the median wholesale trade multiple was slightly above 5.0x, but the 75th percentile multiple for this industry was approximately 10.0x. 

Factors affecting EBITDA multiples

Differences in valuation multiples from company to company reflect differences in risk profiles. High-risk companies command lower multiples than safe investments. The following chart illustrates how certain operational risk factors may affect the valuation multiple.

Other factors that affect valuation multiples include the following:

  • Access to capital
  • Supplier concentration 
  • Supplier pricing advantage 
  • Product or service diversification 
  • Life cycle of current products or services 
  • Geographical distribution 
  • Currency risk 
  • Internal controls 
  • Business owner reliance
  • Legal/litigation issues 
  • Years in operation
  • Location   
  • Demographics 
  • Availability of labor 
  • Employee stability 
  • Internal and external culture 
  • Economic factors 
  • Industry and government regulations 
  • Political factors 
  • Fixed asset age and condition 
  • Strength of intangible assets 
  • Distribution system 
  • IT systems 
  • Technology life cycle 

One model to assess risk and select an appropriate multiple is the exit and succession planning software prepared by MAUS Business Systems (“MAUS”). The MAUS Business Attractiveness model assists analysts in assessing and diagramming the risk profile of a company. This model was developed to assess business attractiveness to potential acquirers based on common risk factors. Analysts can use this software as part of their assessment of an appropriate valuation multiple. This model is also a helpful communication tool because it provides a visual representation of a company’s risk profile and highlights the areas in which a company can improve. 

Using this model, analysts assess a company’s risk profile regarding several key factors. MAUS then generates a report that includes a series of diagrams like the one below. Business attractiveness factors are positioned around the outside of a polygon. If a company performs well regarding a particular factor, a point is plotted towards the outside of the polygon. If the company performs poorly, a point is plotted towards the center of the shape. The points are then connected to visualize a company’s risk profile. 

Business Risk & Value Factors

         

The larger the colored shape is in the MAUS diagram, the higher the valuation multiple should be. However, these factors do not all affect the multiple equally. The valuation multiple may be highly responsive to some factors and less responsive to others. Additionally, each factor may not have a linear effect on the valuation multiple. For these reasons, formula-based estimates of valuation multiples are often inaccurate, although a great place to start for a ballpark indication of value. For matters of importance where accuracy is paramount, we strongly recommend consulting with a valuation professional. In addition to valuation expertise, an outside party provides an independent, unbiased assessment of value. 

Conclusion

The value of a business can be affected dramatically by its risk profile. Analysts value businesses based on a number of different factors that affect value. 

1,2 DealStats Value Index 2Q 2021, Business Valuation Resources, LLC (www.bvresources.com).

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BerryDunn experts and consultants

Read this if you are a business owner or are interested in business valuation. 

BerryDunn’s business valuation team recently authored a book titled A Field Guide to Business Valuation for Owners and Leaders of Private Companies. It is being published by Business Valuation Resources, the leading provider of valuation textbooks, in September. 

A book’s cover can say a lot about a book, and this one is no exception. The title of this book is A Field Guide to Business Valuation. We have organized the book like a field guide used by bird watchers, and encourage readers to keep it on hand as a reference. It doesn’t necessarily need to be read cover to cover. Jump around. If a question comes up about a particular topic, turn to the section that addresses that matter. Or, if learning all about business valuation sounds appealing, by all means read it cover to cover. You may find more to certain topics than you initially thought. Here are some of our notes about the book.

We wrote this book based on data from the field. It is based on our experiences helping business owners estimate, preserve, and increase business value. We work with people who don’t have a business valuation background. We regularly use simple analogies to help people understand complicated topics. We get used to answering the same questions that come up, and we have had many opportunities to hone our answers. After years of explaining business valuations in conversations and presentations, we wrote this book to provide more people with a greater understanding of how businesses are valued. 

This book is intended for business owners and their advisors who would like to learn more about how to estimate what a business is worth, what factors affect value, and how to make businesses more valuable. After reading this book, the reader should be conversant in business valuations and comfortable with the overall valuation framework. It is not an exhaustive dissertation on business valuation. There are many other (very thick) books that get into the details, picking up where this book leaves off. This book is for people who want an understanding of how businesses are valued but don’t have the time to read heavy textbooks. 

The book is designed for people who want to learn how to perform valuations themselves. While it doesn’t contain all the details necessary to master the craft of business valuation, it is a great introduction to the topic. 

Our focus is on the valuation of privately held businesses, not publicly traded companies. Public companies can be valued based on their stock prices or various intrinsic valuation models. The value of private and public companies is affected by different factors. 

We hope this book answers questions, provides new insights, and is an enjoyable read. Stay tuned for more details about availability and opportunities to learn more about the content. If you are interested in learning more, please contact Seth Webber or Casey Karlsen.

Article
We wrote the book on business valuation—and it's available now

Read this if you are looking to buy or sell a construction company.

This article was previously published in Construction Accounting and Taxation, January/February 2022 ©2022 Thomson Reuters/Tax & Accounting.

The other day, my wife was telling me about her dad’s friend who used to be a daredevil backcountry skier. He loved cliff drops and had a reckless approach, once quipping, “I’ll find a landing spot on the way down.” 

Our valuation team includes several expert skiers and snowboarders, but we have little in common with this approach. When we ski, we carefully assess the risks before taking action. Because we spent all day assessing risk, we’re far more likely to take a scouting run and develop a couple of alternatives. Even in our wildest days, we would never go off cliffs without first investigating the landing.  

The same approach should be used when acquiring a business. Acquiring a business can be a big financial risk, possibly the biggest financial risk of one’s life. It might even feel like skiing off a cliff. We frequently work with clients that are acquiring businesses, and we recommend a strategy of investigation and analysis, carefully vetting potential acquisitions, before taking action. 

Recent M&A activity

The pandemic caused a drop-off in merger and acquisition (M&A) activity as many companies were focused on the challenges immediately at hand. As shown in the accompanying chart, the sale of construction companies reported in the DealStats database1 dropped by approximately 53% in 2020. 

As the business environment settles down to the “new normal,” M&A activity will likely begin to pick up again. An opportunity created by the pandemic is the opportunity to acquire struggling companies at a discount. Some companies are unable (or unwilling) to adapt to the new business environment and its many challenges. This fact pattern may represent an opportunity for stabilized companies to expand through acquisition. 

There are numerous other reasons to acquire a business. One common reason historically is to expand into a new service area. For example, one of our clients wanted to expand into concrete services, so they acquired a concrete contractor rather than developing those skills in-house. Another residential builder decided to eliminate a bottleneck in the building process by acquiring a roofing contractor. 

Particularly in the current tight labor market, we have observed numerous “acquihires” where the primary motivation for a deal is to secure a key person or team of employees – particularly for in-demand specialty subcontractors. 

Companies also use acquisitions as an opportunity to establish a new geographical footprint. This strategy is especially useful when ties to the community are important in the business development process. The motivation for an acquisition might also be access to a particular client or access to a new niche. 

Growing through acquisition can enable companies to achieve economies of scale and synergistic benefits through elimination of redundancies. Acquiring a competitor may also yield a secondary benefit by eliminating a source of competition. 

All of these opportunities may paint an overoptimistic picture of the benefits of mergers and acquisitions. According to Harvard Business Review, approximately 70% to 90% of acquisitions fail to realize their targeted outcomes.2  There are a myriad of factors that can cause acquisitions to go awry. Keep the following tips in mind that we have learned from our experience working with companies that completed a successful acquisition. 

Tip #1: Avoid being rushed

Acquiring a business is a big decision that will change the trajectory of the acquirer. If one is rushed into a decision, it is easier to miss key pieces of information. If there is not enough time to learn about the business model and make a careful decision, pass on the acquisition. There will always be future opportunities.

Tip #2: Perform rigorous financial due diligence

Two primary factors drive business value: income and risk. Financial due diligence is the process of verifying income and assessing risk. We recommend having a financial due diligence checklist as an organized method to analyze a company that one is acquiring. By following this checklist, one can learn about a company’s income, assets, liabilities, contracts, benefits, and potential problems (customer concentration, claims and litigation issues, management bench strength, etc.). To perform adequate due diligence, request thorough documentation and dig deep. 

We once helped an individual out who was considering acquiring a business that had very limited financial information available. The seller painted a glowing picture of profitability but lacked the financial data to back the claims. With a significant investment on the line, the potential acquirer judiciously passed on this opportunity. He felt that it wasn’t prudent to rely on the word of a stranger in the absence of data. In order to make a good buying decision, require sellers to bring data to the table. Be skeptical. In one of our former careers in engineering, there was a common mantra – in God we trust, everyone else brings data. If it sounds too good to be true, it probably is.

As part of the financial due diligence, review financial statements for at least the last five years. Audited financial statements are preferred. Additionally, request monthly contract schedules showing completed contracts and work-in-progress (WIP). Monthly contract schedules can provide information about the timing of projects, margins over time, information about change orders, billing practices, and the cadence of work for a particular company.

Success in the construction industry hinges on cash management. Construction firms need to bid contracts and manage operations such that they collect payment as soon as possible in order to avoid a liquidity crisis. A positive indicator is the presence of contract liabilities, which represent billings from customers in excess of revenue recognized to date. This “good liability” indicates that project managers are attentive and understand the business aspect of their roles and/or that company has well written contacts allowing them to bill advantageously. In combination with strong cash flows from operations and good working capital metrics, a contract liability in excess of any contract asset is a good indicator of a strong cash management position. 

On the other hand, the alternative is a contract asset. Contract assets, which are often characterized as “bad assets,” represent revenue recognized in excess of amounts billed. In other words, the company does not have an unconditional right to payment. This could be due to poor contract writing, inattention to scope-creep, difficulty negotiating change orders with clients, or just bad billing practices. Contract assets may also be generated in a manner that does not raise concern. For example, a company might work primarily with government entities and therefore be restricted in their ability to pre-bill. In any case, if contract assets are consistent and substantial, one should inquire into what is giving rise to this asset. 

In the event that contract assets are generated through poor business practices, an acquirer may be able to implement their own billing practices to improve the target’s position, but existing poorly written contracts could pose a large liability and claim on cash flow post-merger. 

Tip #3: Analyze key relationships

A valuable component of intangible value is customer relationships. The most valuable customer base is one that is diversified and stable, ideally with contracts in place. Before acquiring a company, assess the risk associated with its customer base by analyzing concentration and the tenure of relationships with key customers. In some cases, customer reviews may also be available through Google and other platforms. 

Relationships with surety and bonding companies as well as subcontractors should also be topics in due diligence. 

Tip #4: Learn about the employees

Many businesses rightly state, “Our employees are our most valuable asset.” What if this valuable asset becomes disgruntled and walks away after a transaction? We recommend probing employee turnover and satisfaction, as well as analyzing employment contracts. External resources may also be available, or discussions with key customers and subcontractors can be revealing. 

Oftentimes, post-merger integration is unsuccessful due to differences in the cultures between the acquirer and the target. During the due diligence process, learn about the target’s culture and consider how it will likely integrate with your company’s existing culture. 

Tip #5: Assess key person dependence

Many companies cannot operate without the current owner in the driver’s seat. Many key processes, business development in particular, run through this individual. Develop an understanding of what would happen to the business without this person’s involvement. The individual in question (the “key person”) might not be the owner, but a key employee that is essential to business operations. Key person dependence represents a threat to the company in the event of the employee’s departure from the company or incapacitation. 

Some questions we often ask to identify and assess key person dependence include the following: 

  • Who is responsible for business development?
  • How important are individual relationships to the development of new work?
  • Do people become customers because of the reputation of the company or the reputation of an individual?
  • Has management began training up the next level of management beneath them?
  • Do any employees have any specialized knowledge or skills that no other employees have that would be difficult to replace?
  • What would happen to the company if a key employee won the lottery and never came into work again?

Tip #6: Have the seller stick around

Business owners are steeped in the knowledge of their business. This know-how may take time to transfer. Signing the seller to an employment agreement and/or earn-out as part of the transaction can provide the acquirer critical time to absorb the seller’s expertise. 

Tip #7: Don’t assume the good times will last forever

Many construction companies have reported strong profitability despite the pandemic. These profits may simply reflect recent economic trends rather than strong business models. If, or when, the economy takes another drop, many businesses will follow suit. Will the business being purchased survive in a difficult economic climate? To answer this question, consider the following strategies.

First, study how they performed in the last economic recession, keeping in mind the rule of thumb that construction industry downturns generally lag two years behind the rest of the economy and last twice as long. Second, compare a company’s growth and profitability to its industry to reveal whether it is a star or simply rising with the tide. In the words of Warren Buffett, “It’s only when the tide goes out that you learn who’s been swimming naked.” Third, study the business model to link their business drivers to economic factors. 

Tip #8: Consider tax and legal consequences

Many people focus their time and energy negotiating the transaction price and disregard the transaction structure. The amount of taxes paid may increase or decrease dramatically based on the transaction structure. However, tax consequences are often given less attention because they are frustrating and complicated. By spending a little extra time on the transaction structure, acquirers can optimize their after-tax sale proceeds. 

Different deal structures may also sever existing liability or create nightmares in the future. Be sure to discuss these with your legal counsel and weigh the potential risks and returns of structure.

Tip #9: Get different perspectives

Discuss the opportunity with trusted friends, families, and mentors. Bringing in different perspectives can cast light on elements that would otherwise have gone unnoticed.  

Bring in professional perspectives as well for tax, legal, and financial items. Contact a professional regarding the purchase price. Businesses are tricky to value. Two people can have disparate opinions about what it is worth. A business valuation can ground the expectations on price and provide a framework to keep “deal emotions” in check. A business valuation could save a considerable amount of money and time. 

We offer this word of caution: avoid blindly relying on the perspectives of others. Bring them in as counsel, but make sure to have a firm understanding of the offered terms and the business model yourself. Think critically about the decision to buy or walk away as the choice is yours to make. 

Conclusion

In both skiing and acquiring a business, we recommend taking calculated risks. Acquiring a business is a big decision and should be taken seriously. There are many benefits to M&A activity, including expanding services offerings, geographical footprint, employee base, and ultimately profitability. In order to ensure the full benefits of a successful acquisition, keep in mind the advice in this discussion when considering acquiring a company. 

1DealStats is a subscription-based database of business transactions available online at www.bvresources.com/.   
2“The Big Idea: The New M&A Playbook” by Clayton M. Christensen, Richard Alton, Curtis Rising, and Andrew Waldeck. Harvard Business Review, March 2011. Accessed online at https://hbr.org/2011/03/the-big-idea-the-new-ma-playbook

Article
Tips for acquiring a construction company

Read this if you are a business owner or an advisor to business owners.

With continued uncertainty in the business environment stemming from the COVID-19 pandemic, now may be a good time to utilize trust, gift, and estate strategies in the transfer of privately held business interests. 

As discussed in our May 26, 2020 article, 2020 estate strategies in times of uncertainty for privately held business owners, there may be opportunity to free up considerable portions of lifetime gift and estate tax exemption amounts. This is due to suppressed values of privately held businesses, the uncertainty surrounding the impact of the 2020 presidential election on tax rates, and future exemption and exclusion thresholds.

An element of consideration is the ability to transfer non-controlling interests in a business. These interests are potentially subject to discounts for lack of control and lack of marketability, which may further reduce the overall value transferred through a given strategy. You could potentially offload a larger percentage of ownership in a business while retaining large portions of the gift and estate lifetime exemption. Part I of this series focused on the discount for lack of control (“DLOC”). Part II focused on the discount for lack of marketability (“DLOM”). In Part III, let’s focus on the application of discounts.

Application of discounts

One area that often trips up people unfamiliar with business valuations is the application of the DLOC and DLOM. These discounts are multiplicative, not additive. The combined effect of a 10% DLOC and a 30% DLOM is not an additive result of 40%, rather a multiplicative result of 37% (mathematically, 1 – [(1 – DLOC) x (1 – DLOM)]). Consider the following example:

Julie has a 10% minority, nonmarketable interest in a business. The equity of the business is worth $1,000,000. Her interest has a pro-rata value of $100,000 (10% of $1,000,000). Julie retained a qualified valuation analyst, who estimated that a 10% discount for lack of control and a 30% discount for lack of marketability were appropriate for the valuation of her interest. The difference in applying these discounts correctly through a multiplicative process and incorrectly through an additive process is demonstrated in the following chart:

It does not matter the order in which a DLOC and a DLOM are applied. Because these discounts are multiplicative, applying either one first will not affect the concluded minority, nonmarketable value.

Conclusion

Business owners are knowledgeable of the facts and circumstances surrounding a business interest. They take a close look at what they are buying before they make an offer. Like most people, they like to be in charge, and they prefer investments that they can readily convert into cash should they so desire. Therefore, people are generally not willing to pay the pro-rata value for a minority interest in a business when the interest lacks control and marketability. To assess appropriate discounts for lack of control and discounts for lack of marketability, consider resources such as those referred to in Part I and Part II of this series, then ensure the selected discounts are appropriate based on the factors specific to the company and interest being valued. From there, the application of the DLOC and DLOM is multiplicative, not additive, as noted in the example above. 

Given the current environment, using trust, gift, and estate strategies that take advantage of discounts for lack of control and marketability offers the opportunity to transfer a higher percentage of interest in a privately held company at a lower value. This potentially frees up additional amounts of remaining thresholds of the lifetime gift and estate tax exemptions. 

Our mission at BerryDunn remains constant in helping each client create, grow, and protect value. If you have questions about your unique situation, or would like more information, please contact the business valuation consulting team.  

Article
Discounts for lack of control and marketability in business valuations (Part III)

Read this is you are a business owner or an advisor to business owners.

With continued uncertainty in the business environment stemming from the COVID-19 pandemic, now may be a good time to utilize trust, gift, and estate strategies in the transfer of privately held business interests. 

As discussed in our May 26, 2020 article 2020 estate strategies in times of uncertainty for privately held business owners, there may be opportunity to free up considerable portions of lifetime gift and estate tax exemption amounts. This is possible due to suppressed values of privately held businesses and the uncertainty surrounding the impact of the 2020 presidential election on tax rates and future exemption and exclusion thresholds.

An element to consider is the ability to transfer non-controlling interests in a business. These interests are potentially subject to discounts for lack of control and lack of marketability. The discounts may further reduce the overall value transferred through a given strategy, potentially offloading a larger percentage of ownership in a business while retaining large portions of the gift and estate lifetime exemption. Part I of this series focused on the discount for lack of control. In Part II, let’s focus on the discount for lack of marketability.

Discount for lack of marketability

In the context of a hypothetical willing buyer and willing seller, the buyer may place a greater value on an ownership interest of an investment that is “marketable.” Marketable investments can be bought and sold easily and offer the ability to extract liquidity compared to an interest where transferability and marketability are limited. 

Simply put, buyers would rather own investments they can sell easily, and will pay less for the investment if it lacks this ability. Non-controlling interests in private businesses lack marketability—few people are interested in investing in a business where control rests in someone else’s hands. Discounts for lack of control commonly reduce the value of the transferred interest by 5% to 15%, discounts for lack of marketability can drop value of the business by 25% to 35%.

Market-based evidence of proxies for discounts for lack of marketability can be found within the following resources, studies, and methods (including, but not limited to):

  • Various restricted stock studies
  • The Quantitative Marketability Discount Model (QMDM) developed by Z. Christopher Mercer
  • Various pre-initial public offering studies
  • Option pricing models
  • Other discounted cash flow models

In addition to these resources, to fully assess the degree of discount applicable to a subject interest, consider company-specific factors when estimating the discount for lack of marketability. The degree of marketability is dependent upon a wide range of factors, such as the payment of dividends, the existence of a pool of prospective buyers, the size of the interest, any restrictions on transfer, and other factors. 

To establish a comprehensive view on the applicable degree of discount, here are more things go consider. In a ruling on the case Mandelbaum v. Commissioner1, Judge David Laro outlined the primary company-specific factors affecting the discount for lack of marketability, including:

  1. Restrictions on transferability and withdrawal
  2. Financial statement analysis
  3. Dividend policy
  4. The size and nature of the interest
  5. Management decisions
  6. Amount of control in the transferred shares

Conclusion

Business owners are knowledgeable of the facts and circumstances surrounding a business interest. They take a close look at what they are buying before they make an offer. Like most people, they prefer investments they can readily convert into cash, and are therefore generally not willing to pay the pro-rata value for a minority interest in a business when the interest lacks marketability. To assess an appropriate discount for lack of marketability, consider resources such as those referred to above, then ensure selected discounts are appropriate based on the factors specific to the company and interest being valued. 

Our mission at BerryDunn remains constant in helping each client create, grow, and protect value. If you have questions about your unique situation, or would like more information, please contact the business valuation consulting team.

Part III of this series will focus on the application of DLOC and DLOM to a subject interest.

1Mandelbaum v. Commissioner, T.C. Memo 1995-255 (June 13, 1995).

Article
Discounts for lack of control and marketability in business valuations (Part II)

Read this is you are a business owner or an advisor to business owners.

With continued uncertainty in the business environment stemming from the COVID-19 pandemic, now may be a good time to utilize trust, gift, and estate strategies in the transfer of privately held business interests. 

As discussed in our May 26, 2020 blog post 2020 estate strategies in times of uncertainty for privately held business owners, there may be opportunity to free up considerable portions of lifetime gift and estate tax exemption amounts through transfers due to suppressed values of privately held businesses, and the uncertainty surrounding the impact of the 2020 presidential election on tax rates and future exemption and exclusion thresholds. 

An element to consider when building on this opportunity is the ability to transfer non-controlling interests in a business. These interests are potentially subject to discounts for lack of control and lack of marketability. This may further reduce the overall value transferred through a given strategy, potentially offloading a larger percentage of ownership in a business while retaining large portions of the gift and estate lifetime exemption. Let’s focus on the discount for lack of control (DLOC).

Discount for lack of control

In the context of a hypothetical willing buyer and willing seller, the buyer may place a greater value on an ownership interest with the ability to make changes at their discretion, compared to an alternative ownership interest lacking control. Simply put, buyers like to be in control, and they will pay less for the investment if the interest lacks these characteristics. 

When valuing non-controlling business interests there is an inherent discount to full value recognized to reflect the fact that the subject interest does not hold a controlling position. As a result of this discount, the value of a non-controlling interest in a company will differ from the pro-rata value per share of the entire company. DLOCs alone commonly reduce the value of the transferred interest by 5% to 15%.

All else being equal, a non-controlling ownership position is less desirable (valuable) than a controlling position. This is because of the majority owner’s right to control any or all of the following activities: managing the assets or selecting agents for this purpose, controlling major business decisions, asset allocation choices, setting salary levels, admitting new investors, acquiring assets, selling the company, and declaring/paying distributions.
 
Market-based evidence of proxies for DLOCs can be found within the following subscription-based databases (including, but not limited to): 

  • Control premium studies published in the Mergerstat® Review series by FactSet Mergerstat/Business Valuation Resources
  • Closed-end fund data
  • The Partnership Profiles, Inc. Minority Interest Database and Executive Summary Report on Re-Sale Discounts for applicable entity types

In addition to these resources, to fully assess the degree of discount applicable to a subject interest, consider company-specific factors when estimating the DLOC. The degree of control for a subject interest may be impacted by relevant state statutes and the governing documents of the subject company. These factors are analyzed in conjunction with the current operational and financial policies established and implemented in practice by management to establish a comprehensive view on the applicable degree of discount.

Conclusion

Hypothetical business owners are knowledgeable of the facts and circumstances surrounding a business interest. They take a close look at what they are buying before they make an offer. Like most people, they like to be in charge, and are therefore generally not willing to pay the pro-rata value for a minority interest in a business when the interest lacks control. To assess an appropriate discount for lack of control, consider resources such as those referred to above, then ensure the selected discounts are appropriate based on the factors specific to the company and interest being valued. 

Our mission at BerryDunn remains constant in helping each client create, grow, and protect value. If you have questions about your unique situation, or would like more information, please contact the business valuation consulting team.

Article
Discounts for lack of control and marketability in business valuations

I leaned out of my expansive corner office (think: cubicle) and asked my coworker Andrew about an interesting topic I had been thinking about. “Hey Andrew, do you know what BATNA stands for?” I asked. Andrew, who knows most things worth knowing, indicated that he didn’t know. This felt good, as there are very few things that I know that Andrew doesn’t. 

BATNA, which stands for “best alternative to no agreement”, is very relevant to business owners who may at some point want to sell their business. It’s a relatively simple concept with significant implications in the context of negotiations, as the strength of your negotiating position depends on what happens if the deal falls through (i.e., if there is no agreement). Put another way, your negotiating position is dependent on your "next best alternative", but I’m pretty sure the acronym NBA is already being used.

If you have 100 potential buyers lined up, you have a strong negotiating position. If the first buyer backs out of the deal, you have 99 alternatives. But if you have only one potential buyer lined up, you have a weak negotiating position. Simple, right?

BATNA is applicable to many areas of our life: buying or selling a car, negotiating the price of a house, or even choosing which Netflix show to watch. Since I specialize in valuations, let’s talk about BATNA and valuations, and more specifically, fair market value versus investment value.

Fair Market Value

The International Glossary of Business Valuation Terms defines fair market value as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”

Think about fair market value as the price that I would pay for, for example, a Mexican restaurant. I have never owned a Mexican restaurant, but if the restaurant generates favorable returns (and favorable burritos), I may want to buy it. Fair market value is the price that a hypothetical buyer such as myself would pay for the restaurant. 

Investment Value

The International Glossary of Business Valuation Terms defines investment value as “the value to a particular investor based on individual investment requirements and expectations.”

Think about investment value as the price that the owner of a chain of Mexican restaurants would pay for a restaurant to add to their portfolio. This strategic buyer knows that because they already own a chain of restaurants, when they acquire this restaurant, they can reduce overhead, implement several successful marketing strategies, and benefit from other synergies. Because of these cost savings, the restaurant chain owner may be willing to pay more for the restaurant than fair market value (what I would be willing to pay). As this example illustrates, investment value is often higher than fair market value.

As a business owner you may conclude “Well, if investment value is higher than fair market value, I would like to sell my business for investment value.” I agree. I absolutely agree. Unfortunately, obtaining investment value is not a guaranteed thing because of… you guessed it! BATNA. 

Business owners may identify a potential strategic buyer and hope to obtain investment value in the sale. However, in reality, unless the business owner has identified a ready pool of potential strategic buyers (notice the use of the plural here), they may not be in a negotiating position to command investment value. A potential strategic buyer may realize if they are the only potential strategic buyer of a company, they aren’t competing against anybody offering more than fair market value for the business. If there isn’t any agreement, the business owner’s best alternative is to sell at fair market value. Realizing this, a strategic buyer will likely make an offer for less than investment value. 

If you are looking to sell your business, you need to put yourself in a negotiating position to command a premium above fair market value. You need to identify as many potential buyers as possible. With multiple potential strategic buyers identified, your BATNA is investment value. You will have successfully shifted the focus from a competition for your business to a competition among strategic buyers. Now, the strategic buyers will be concerned with their own BATNA, rather than yours. And that’s a good thing.

We frequently encounter clients surprised by the difficulty of commanding investment value for the sale of their business. BATNA helps explain why business owners are unable to attain investment value. 

At BerryDunn, we perform business valuations under both the investment value standard and the fair market value standard.

If you have any questions about the value of your business, please contact a professional on our business valuation team

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BATNA: What you need to know

Read this if your company is a benefit plan sponsor.

While plan sponsors have been able to amend their 401(k) plans to include a post-tax deferral contribution called Roth for more than a decade, only 86% of plan sponsors have made it available to participants, according to the Plan Sponsor Council of America. Meanwhile, despite the potential benefits of such plans, just a quarter of participants who have access to the Roth 401(k) option use it. Plan sponsors may want to consider adding a Roth 401(k) option to their lineup because of the potential tax benefits and other advantages for plan participants.

A well-designed Roth 401(k) may be an attractive option for many plan participants, and it is important for plan sponsors considering such a feature to design the plan with the needs of their workforce in mind. It is also critical to clearly communicate the differences from the pre-tax option, specific timing rules required, and the tax-free growth it offers. Additionally, plan sponsors should be mindful of potential administrative costs and other compliance requirements in connection with allowing the Roth option.

Roth 401(k)s: The basics

A Roth is a separate contribution source within a 401(k) or 403(b) plan that differs from traditional retirement accounts because it allows participants to contribute post-tax dollars. Since participants pay taxes on these contributions before they are invested in the account, plan participants may make qualified withdrawals of Roth monies on a tax-free basis, and their accounts grow tax-free as well.

Participants of any income level may participate in a Roth 401(k) and may contribute a maximum of $20,500 in 2022—the same limit as a pre-tax 401(k). Contributions and earnings in a Roth 401(k) may be withdrawn without paying taxes and penalties if participants are at least 59½ and it’s been at least five years since the first Roth contribution was made to the plan. Participants may make catch-up contributions after age 50, and they may split their contributions between Roth and pre-tax. Similar to pre-tax 401(k) accounts, Roth 401(k) assets are considered when determining minimum distributions required at age 72, or 70 ½ if they reached that age by Jan. 1, 2020.

Only employee elective deferrals may be contributed post-tax into Roth 401(k) accounts. Employer contributions made by the plan sponsor, such as matching and profit sharing, are always pre-tax contributions. If the plan allows, participants may convert pre-tax 401(k) assets into a Roth account, but it is critical to remember that doing so triggers taxable income and participants must be prepared to pay any required tax. In addition, plan sponsors must be careful to offer Roth 401(k)s equally to all participants rather than just a select group of employees.

Qualified distributions from a designated Roth account are excluded from gross income. A qualified distribution is one that occurs at least five years after the year of the employee’s first designated Roth contribution (counting the first year as part of the five) and is made on or after age 59½, on account of the employee’s disability, or on or after the employee’s death. Non-qualified distributions will be subject to tax on the earnings portion only, and the 10% penalty on early withdrawals may apply to the part of the distribution that is included in gross income. Participants may take out loans if permitted in the plan document. 

First steps for plan sponsors

A common misconception among plan sponsors is that a Roth offering requires a completely different investment vehicle. The feature is simply an added contribution option; therefore, no separate product is needed.

When considering the addition of a Roth 401(k) option, it is important for plan sponsors to check with service providers to determine whether payroll may be set up properly to add a separate deduction for the participant. Plan sponsors may also need to consider guidelines for conversions, withdrawals, loans, and other features associated with the Roth contribution source to ensure the plan document is prepared and followed accurately.

Education is an important component of any new plan feature or offering. Plan sponsors should check with service providers to see how they may help to explain the feature and optimize its rollout for the plan. One-on-one meetings with participants may be very helpful in educating them about a Roth account.

A word about conversions

If permitted by the plan document, participants may convert pre-tax 401(k) plan assets (deferrals and employer contributions) to the Roth source within their plan account. The plan document may allow for entire account conversions or just a stated portion. When assets are converted, participants must pay income taxes on the converted amount, and the additional 10% early withdrawal tax won’t apply to the rollover. Plan sponsors should educate participants on the benefits of converting to the Roth inside the company 401(k).

Collaborate with the right service providers to educate your participants

The right service providers may review your current plan design, set up accounts properly, actively engage and educate your participants, and offer financial planning based on individual circumstances to show how design features like a Roth account may benefit their situation. If you would like to start the conversation about adding a Roth option or enhancing your participant education program, contact our employee benefits team. We are here to help. 

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Plan sponsor alert: Roth 401(k) remains underutilized despite potential benefits