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Why a business valuation analysis is important to your company's value

07.24.18

All business owners need to consider a business valuation, ideally updated annually. A current business valuation is important for your company’s financial health as it can:

  • Give you an accurate picture of what your company is really worth — and how transferable that value can be — this provides a realistic picture of your company’s value should you decide to sell. It also provides a window into your ability to grow the business and how much money a bank would be willing to lend to support that growth.
  • Help you to plan for a faster sale — proper planning delivers more lucrative and successful sales of small businesses, as it gives a business owner time to increase the company’s worth before the sale, and to sell quickly.
  • Protect your family if something happens to you. John Warrillow, founder of The Value Builder System, writes that illness is the number one event that forces business owners to sell. A business valuation analysis can identify ways to create a more transferrable business in the event of illness or death.

Overall, a business valuation professional can provide you with an exact value of your company and help you develop a long-term plan to increase its value. Valuation strategies can help you increase profitability by helping you:

  • Identify prospective opportunities for sales growth
  • Implement cost-cutting strategies that maximize profits
  • Increase employee retention and save money on hiring and training
  • Develop systems and processes to increase the odds of a successful transition to the new owners, whoever they may be

If you or your client is interested in increasing a company’s value, please contact Seth Webber 

Topics: manufacturing

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What are the top three areas of improvement right now for your business? In this third article of our series, we will focus on how to increase business value by aligning values, decreasing risk, and improving what we call the “four C’s”: human capital, structural capital, social capital, and consumer capital.

To back up for a minute, value acceleration is the process of helping clients increase the value of their business and build liquidity into their lives. Previously, we looked at the Discover stage, in which business owners take inventory of their personal, financial, and business goals and assemble information into a prioritized action plan. Here, we are going to focus on the Prepare stage of the value acceleration process.

Aligning values may sound like an abstract concept, but it has a real world impact on business performance and profitability. For example, if a business has multiple owners with different future plans, the company can be pulled in two competing directions. Another example of poor alignment would be if a shareholder’s business plans (such as expanding the asset base to drive revenue) compete with personal plans (such as pulling money out of the business to fund retirement). Friction creates problems. The first step in the Prepare stage is therefore to reduce friction by aligning values.

Reducing risk

Personal risk creates business risk, and business risk creates personal risk. For example, if a business owner suddenly needs cash to fund unexpected medical bills, planned business expansion may be delayed to provide liquidity to the owner. If a key employee unexpectedly quits, the business owner may have to carve time away from their personal life to juggle new responsibilities. 

Business owners should therefore seek to reduce risk in their personal lives, (e.g., life insurance, use of wills, time management planning) and in their business, (e.g., employee contracts, customer contracts, supplier and customer diversification).

Intangible value and the four C's

Now more than ever, the value of a business is driven by intangible value rather than tangible asset value. One study found that intangible asset value made up 87% of S&P 500 market value in 2015 (up from 17% in 1975). Therefore, we look at how to increase business value by increasing intangible asset value and, specifically, the four C’s of intangible asset value: human capital, structural capital, social capital, and consumer capital. 

Here are two ways you can increase intangible asset value. First of all, do a cost-benefit analysis before implementing any strategies to boost intangible asset value. Second, to avoid employee burnout, break planned improvements into 90-day increments with specific targets.

At BerryDunn, we often diagram company performance on the underlying drivers of the 4 C’s (below). We use this tool to identify and assess the areas for greatest potential improvements:

By aligning values, decreasing risk, and improving the four C’s, business owners can achieve a spike in cash flow and business value, and obtain liquidity to fund their plans outside of their business.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

Article
The four C's: Value acceleration series part three (of five)

This is our second of five articles addressing the many aspects of business valuation. In the first article, we presented an overview of the three stages of the value acceleration process (Discover, Prepare, and Decide). In this article we are going to look more closely at the Discover stage of the process.

In the Discover stage, business owners take inventory of their personal, financial, and business goals, noting ways to increase alignment and reduce risk. The objective of the Discover stage is to gather data and assemble information into a prioritized action plan, using the following general framework.

Every client we have talked to so far has plans and priorities outside of their business. Accordingly, the first topic in the Discover stage is to explore your personal plans and how they may affect business goals and operations. What do you want to do next in your personal life? How will you get it done?

Another area to explore is your personal financial plan, and how this interacts with your personal goals and business plans. What do you currently have? How much do you need to fund your other goals?

The third leg of the value acceleration “three-legged stool” is business goals. How much can the business contribute to your other goals? How much do you need from your business? What are the strengths and weaknesses of your business? How do these compare to other businesses? How can business value be enhanced? A business valuation can help you to answer these questions.

A business valuation can clarify the standing of your business regarding the qualities buyers find attractive. Relevant business attractiveness factors include the following:

  • Market factors, such as barriers to entry, competitive advantages, market leadership, economic prosperity, and market growth
  • Forecast factors, such as potential profit and revenue growth, revenue stream predictability, and whether or not revenue comes from recurring sources
  • Business factors, such as years of operation, management strength, customer loyalty, branding, customer database, intellectual property/technology, staff contracts, location, business owner reliance, marketing systems, and business systems

Your company’s performance in these areas may lead to a gap between what your business is worth and what it could be worth. Armed with the information from this assessment, you can prepare a plan to address this “value gap” and look toward your plans for the future.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

Next up in our value acceleration series is all about what we call the four C's of the value acceleration process. 

Article
The discover stage: Value acceleration series part two (of five)

This is the first article in our five-article series that reviews the art and science of business valuation. The series is based on an in-person program we offer from time to time.  

Did you know that just 12 months after selling, three out of four business owners surveyed “profoundly regretted” their decision? Situations like these highlight the importance of the value acceleration process, which focuses on increasing value and aligning business, personal, and financial goals. Through this process, business owners will be better prepared for business transitions, and therefore be significantly more satisfied with their decisions.

Here is a high-level overview of the value acceleration process. This process has three stages, diagrammed here:

The Discover stage is also called the “triggering event.” This is where business owners take inventory of their situation, focusing on risk reduction and alignment of their business, personal, and financial goals. The information gleaned in this stage is then compiled into a prioritized action plan utilized in future stages.

In the Prepare stage, business owners follow through on business improvement and personal/financial planning action items formed in the discover stage. Examples of action items include the following:

  • Addressing weaknesses identified in the Discover stage, in the business, or in personal financial planning
  • Protecting value through planning documents and making sure appropriate insurance is in place
  • Analyzing and prioritizing projects to improve the value of the business, as identified in Discover stage
  • Developing strategies to increase liquidity and retirement savings

The last stage in the process is the Decide stage. At this point, business owners choose between continuing to drive additional value into the business or to sell it.

Through the value acceleration process, we help business owners build value into their businesses and liquidity into their lives.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

Read more! In our next installment of the value acceleration blog series, we cover the Discover stage.

Article
The process: Value acceleration series part one (of five)

Read this if you are a business owner or involved in estate planning.

I have some good news, and I have some bad news. Here’s the bad news. Inflation impacts our lives in countless ways—spending, interest rates, savings, business decisions—driven by economic cycles beyond our control. Price increases are observable across the entire spectrum of goods and services. Businesses able to pass on increases in sustainability may continue benefiting from these general increases, but only to a point. These increases are characteristic of late expansion and slowdown phases of economic cycles and typically top out in a contractionary phase. Economic policy, by way of restrictive monetary policies, aims to reign in the acceleration rate of inflation. This impact is typically subject to a time lag in observation. Economic decline, holding all else equal, typically results in lower overall profitability and depressed business value. Increased uncertainty, holding all else equal, typically results in higher costs of capital, which in turn results in depressed business value. Bad news indeed.

Now for the good news. A potential silver lining exists. You may have the ability to transfer a larger portion of ownership of privately held business interests at lower levels of value—while annual exclusions are increasing because of inflation. Here’s how.

Federal gift tax annual exclusion increasing

For the tax year ending December 31, 2022, the federal gift tax annual exclusion is $16,000 per individual ($32,000 per married couple choosing to split gifts) for 2022. IRC § 2503 (b)(2) allows for inflationary adjustments to annual gift tax exclusion, but only in $1,000 increments. Based on inflationary adjustments, the federal gift tax annual exclusion for 2023 is $17,000 per individual ($34,000 per married couple choosing to split gifts). The gift tax annual exclusion allows a taxpayer to gift a certain amount to a recipient each year without using any of the taxpayer’s lifetime exemption amount. 

For gifts over and above an annual exclusion amount, each taxpayer receives a lifetime transfer tax exemption, which is unified for both federal gift and estate taxes. At current 2022 levels, the lifetime exemption amount is $12.06 million for each taxpayer, or $24.12 million for married couples. Inflationary adjustments impact this amount as well. For 2023 the lifetime exemption is $12.92 million for each taxpayer, or $25.84 million for married couples. That is an increase of almost $900,000 per taxpayer in one year. 

Gifting strategies

Knowing the current and future annual exclusion and lifetime exemption amounts, privately held business owners may make use of efficient gifting strategies in straddling the calendar year reference date of valuation. In this example, the subject company and subject interest would be valued on distinct sides of the calendar year with one primary analysis using very similar financial data (a balance sheet as of December 31, 2022, may closely resemble a balance sheet on January 1, 2023). The primary analysis may allow the privately held business owners to accomplish 2022 and 2023 planning in one fell swoop.

If transfers through gifting are already part of your overall long-term wealth and estate plan, accelerating parts of these plans may make sense—particularly as lifetime exemptions are at historically high levels. 

2017 Tax Cuts and Jobs Act 

The 2017 Tax Cuts and Jobs Acts provides for reversion of the lifetime exemption amount back to $5 million (adjusted for post-2011 inflation) for each taxpayer and $10 million (adjusted for post-2011 inflation) for married couples after the year 2025.

If considering gifting strategies as part of your overall wealth and estate plan, consult your professional legal and accounting teams to fully understand whether additional gifts can or should be made in 2022 and in 2023 for tax planning purposes.

Article
An inflationary silver lining for privately held businesses

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 Chief Financial Officer, Chief Compliance Officer, FINOP, or charged with governance of a broker-dealer.

The results of the Public Company Accounting Oversight Board’s (PCAOB) 2020 inspections are included in its 2020 Annual Report on the Interim Inspection Program Related to Audits of Brokers and Dealers. There were 65 audit firms inspected in 2020 by the PCAOB and, although deficiencies declined 11% from 2019, 51 firms still had deficiencies. This high level of deficiencies, as well as the nature of the deficiencies, provides insight into audit quality for broker-dealer stakeholders. Those charged with governance should be having conversations with their auditor to see how they are addressing these commonly found deficiencies and asking if the PCAOB identified any deficiencies in the auditor’s most recent examination. 

If there were deficiencies identified, what actions have been taken to eliminate these deficiencies going forward? Although the annual report on the Interim Inspection Program acts as an auditor report card, the results may have implications for the broker-dealer, as gaps in audit quality may mean internal control weaknesses or misstatements go undetected.

Attestation Standard (AT) No. 1 examination engagements test compliance with the financial responsibility rules and the internal controls surrounding compliance with the financial responsibility rules. The PCAOB examined 21 of these engagements and found 14 of them to have deficiencies. The PCAOB continued to find high deficiency rates in testing internal control over compliance (ICOC). They specifically found that many audit firms did not obtain sufficient, appropriate evidence about the operating effectiveness of controls important to the auditor’s conclusions regarding the effectiveness of ICOC. This insufficiency was widespread in all four areas of the financial responsibility rules: the Reserve Requirement rule, possession or control requirements of the Customer Protection Rule, Account Statement Rule, and the Quarterly Security Counts Rule.

The PCAOB also identified a firm that included a statement in its examination report that referred to an assertion by the broker-dealer that its ICOC was effective as of its fiscal year-end; however, the broker-dealer did not include that required assertion in its compliance report.

AT No. 2 review engagements test compliance with the broker-dealer’s exemption provisions. The PCAOB examined 83 AT No. 2 engagements and found 19 of them to have deficiencies. The most significant deficiencies were that audit firms:

  • Did not make required inquiries, including inquiries about controls in place to maintain compliance with the exemption provisions, and those involving the nature, frequency, and results of related monitoring activities.
  • Similar to AT No. 1 engagements, included a statement in their review reports that referred to an assertion by the broker-dealer that it met the identified exemption provisions throughout the most recent fiscal year without exception; however, the broker-dealers did not include that required assertion in their exemption reports.

The majority of the deficiencies found were in the audits of the financial statements. The PCAOB did not examine every aspect of the financial statement audit, but focused on key areas. These areas were: revenue, evaluating audit results, identifying and assessing risks of material misstatement, related party relationships and transactions, receivables and payables, consideration of an entity’s ability to continue as a going concern, consideration of materiality in planning and performing an audit, leases, and fair value measurements. Of these areas, revenue and evaluating audit results had the most deficiencies, with 45 and 27 deficiencies, or 47% and 26% of engagements examined, respectively.

Auditing standards indicate there is a rebuttable presumption that improper revenue recognition is a fraud risk. In the PCAOB’s examinations, most audit firms either identified a fraud risk related to revenue or did not rebut the presumption of revenue recognition as a fraud risk. These firms should have addressed the risk of material misstatement through appropriate substantive procedures that included tests of details. The PCAOB noted there were instances of firms that did not perform any procedures for one or more significant revenue accounts, or did not perform procedures to address the assessed risks of material misstatement for one or more relevant assertions for revenue. The PCAOB also identified deficiencies related to revenue in audit firms’ sampling methodologies and substantive analytical procedures. Other deficiencies of note, that were not revenue related, included:

  • Incomplete qualitative and quantitative disclosure information, specifically in regards to revenue from contracts with customers and leases.
  • Missing required elements from the auditor’s report.
  • Missing auditor communications:
    • Not inquiring of the audit committee (or equivalent body) about whether it was aware of matters relevant to the audit.
    • Not communicating the audit strategy and results of the audit to the audit committee (or equivalent body).
  • Engagement quality reviews were not performed for some audit and attestation engagements.
  • Audit firms assisted in the preparation of broker-dealer financial statements and supplemental information.

Although there have been improvements in the amounts of deficiencies found in the PCAOB’s examinations, the 2020 annual report shows that there is still work to be done by audit firms. Just like auditors should be inquiring of broker-dealer clients about the results of their most recent FINRA examination, broker-dealers should be inquiring of auditors about the results of their most recent PCAOB examination. Doing so will help broker-dealers identify where their auditor may reside on the audit quality spectrum. If you have any questions, please don’t hesitate to reach out to our broker-dealer services team.

Article
2020 Annual Report on the Interim Inspection Program Related to Audits of Brokers and Dealers

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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Factors affecting the value of a company