Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.
Chuck Lefebvre: This is Chuck.
Ed Sutkowski: I’m Ed. Today’s opportunity, we’re talking to two individuals associated with Sikich, which is a well-recognized accounting firm. We have Neil Gerber, who is a director. Neil, say hi.
Neil Gerber: Hello.
Ed: We have Glen Birnbaum, who is a partner. Glen, say hi for us.
Glen Birnbaum: Hello, this is Glen.
Ed: Our topic today is value, actually, valuation. Value, we’re not talking about the feel good value that you’re in love, you feel good. We’re talking about quantitative value. How do you value a business opportunity, a farm, other assets? These folks have been involved in this activity for more than a few decades, and so they’re the resident experts in the tri-county area as to how we value certain aspects. Either view, let’s talk about why a value is necessary. What goes on? What’s a typical source of request for a value?
Neil: Well, first, the question is when we say value, the value of what? Specifically, Glen and I do business valuations, operating businesses, holding companies. We’re not real estate appraisers or equipment appraisers, so we’re valuing businesses. The reason we get asked to value businesses are anything anywhere from just the owner wants just to do it for financial planning purposes, estate planning purposes. We do estate valuations for gifting purposes. Glen does a lot of merger and acquisition work where we have clients that want to buy a business or sell a business, and so knowing the value of the business is necessary for that, and then occasionally, mergers when you’re merging two companies together in a tax-free way.
Ed: Now, when you say a merger, what do you mean by that? Will you expand? What is a merger?
Neil: Occasionally, Company A and Company B want to join forces, and so they’ll exchange their stock into a new company, new Co. They’re doing that for business reasons or some sort of synergy they gain by working together and they want to have joint ownership, so we get asked to value each respective business so the owners of new Co. know how much of the total they get respectively.
Ed: That’s a marriage then. Two companies.
Neil: Yes, good analogy, Ed.
Ed: Well, speaking marriages, do you get involved in divorce valuations?
Glen: This is Glen. Neil’s a little more involved in the divorce side, but yes, we do get involved in those situations where you’ve got to try to divide up the marital state. Oftentimes, a privately held business can be a big asset if somebody’s getting divorced and a big part of their net worth that you might have investments in a 401k plan or whatever, but as Neil said, we don’t value that stuff. We value stuff that’s not traded every day and where you don’t see the stock price in The Wall Street Journal every morning.
Ed: We’re talking about a value for divorce purposes. Chuck, do we need two valuation experts? One for a husband and one for a wife?
Chuck: At least two.
Glen: Three is preferable.
Chuck: The thing I noticed that you didn’t mention the list of things that come up for valuation is bank lending. I know that that seems to be– they do it all in-house or they don’t care, they’re just looking at cash flow. What’s your assessment of that?
Glen: It’s a good– I don’t know that we’ve done much of that. It’s mostly based on hard assets, at least the banks we deal with, not a whole lot of cash-flow lending. What cash-flow lending is done, the banks do it on their own, their own covenants, their own ratios, so we don’t really get involved.
Neil: We’ve done the SBA lending, though. They require an independent valuation done. For those, we’ve been asked to work with.
Ed: Okay. We know the nature and extent of the value. Let’s talk about the methodology. Is it just a one-off arrangement, or is there multiple procedures you apply? You’ve talked about assets, comparable sales, cash– How do you arrive at a value of a business organization? Let’s say one manufactures widgets that has a cash-flow of X thousands of dollars a month. How do you go about valuing this?
Glen: Well, there’s three main approaches and you touched on them there. There’s what’s called the asset approach or the cost approach, there’s the income approach, and then there’s the market approach, so three different ways. I like to compare it to appraising a house, and as Neil said, we’re not real estate appraisers, but for a house, it’s like, how much does it cost to build the house? That’s the asset approach or the cost approach. The second method is hey, what could I rent my house out for? That’s the income approach, how much cash flow is being generated. The third approach, which is the market approach is, the comparable sales like, what’s the house selling for down the street? All appraisal is the same. We use those three main approaches. We just apply them to smaller privately held businesses.
Chuck: How do you decide how to blend them together? It seems like a lot of valuation reports. I see they’ll go through those three, and then they essentially just pick one. I know you can blend them, but it seems quite often they’ll say, “Well, we’re just doing the cash flow approach here, capitalized cash flow on this.”
Neil: Good question, Chuck. For operating companies, the real world is more interested in its cash flow, so you’re going to almost always place more weight on that than just simply the cost or the asset approach. That tends to be a floor value for most operating companies. What would they get if they liquidated? We’re going to typically go with the income and the market approach. Both of those are going to be– The market approach itself’s based on, you’re using EBITDA multiples, earnings multiples.
Ed: Wait a minute. What’s this EBITDA thing? What’s that all about?
Neil: When you hear a price multiple, it’s the earnings of the business times an appropriate valuation multiple. When you hear price multiples, one of the most common for businesses is called an EBITDA price multiple. EBITDA means the earnings of the business before interest, taxes, depreciation, and amortization. E-B-I-T-D-A.
Ed: Think that as an apartment building. We talked about an apartment manager and then suggest in easy terms for me to understand is, you’ve got rent coming in, net rent, you’ve got depreciation. The sum of those two, with or without regard to property taxes, how much cash is being generated? Then they decide what should be the cap rate. Help me understand that, the capitalization rate. How does that work and what does it mean?
Neil: A capitalization rate is just a fancy word for the price multiple.
Chuck: You get to charge more if you call it a capitalization rate.
Neil: I think most people have heard of PE multiples, price earnings multiple, so that cap rate effectively is the multiple. It’s just expressed as the inverse.
Ed: Five times, or 10 times, or 11 times, and so you get to those multiples by reference to what?
Neil: Great question. That’s why people hire us, to find out what the appropriate multiple is, and so that’s why we do the market research. We have part of valuations. We got to look at the company, what’s driving its success, what’s its true earnings, and then what industry does it operate in, and where’s that industry going, and what are the multiples in that industry.
Ed: Do we have outliers? You can have a very, very unique situation more specifically. We’ve got a combination of low-interest rates and you have to identify if it’s a buy or sell situation. The buyer is the buyer one of a group that is adding on to an existing business they have, or is it freestanding? How do all these things, interest rates, identity of the buyer, bear on what is your view of the value of the widget manufacturing company?
Glen: That’s a good question. Just to dive a little deeper on the market approach. There’s the public markets that we look at as a proxy, but then we also have some access to some private databases, smaller companies that are traded that are at least sold the last say, five years, but the real challenge going back to my house example is, how comparable is the company to the company we’re valuing? With a house, it’s probably a lot easier to say, “Hey, this house down the street is probably similar square footage, number of bedrooms, that type of thing.” For a business, what you’re talking about it as you get into things like customer concentration and what is the interest rate environment at the time. It can be very hard to really find that true comparable when you’re looking at the market approach, just because businesses are a lot more varied and diverse than real estate or a house.
Ed: Well, what about compensation? Do you have it adjusted for capital expenditures that exceed a normal capital expenditure, executive compensation, or neither, or both, or either? You’ve got an individual, a seller is trying to get a value. That person, if he is the entrepreneur thinks that it’s the greatest thing since sliced bread. How do you tone that person down?
Glen: That’s a good question. We think about it in a, “Hey, I’m going to come into this business and I’ve got to hire the right talent and I’m going to invest in it pretty passively, not be very active. What do I have to pay somebody to do that type of work?” Owner’s compensation can either be high. It can be low. Just because we’re an accounting firm, but just because the accountants signed off on the audit report doesn’t necessarily mean that the owner’s compensation is market. We’re always looking to adjust just to market. Now, sometimes what we’ll do, Ed, is just bypass the issue or sidestep it and just say, we’re going to look at the net income of the business and just add back owner’s compensation. It’s called seller’s discretionary cash flow. That’s a little more typical for smaller businesses where you don’t really separately say what the owners efforts are. You just add it back and figure that the likely buyer might be somebody who’s also looking to buy a job as well as a business. You do the multiple based off of net income plus owner’s compensation.
Chuck: It gets around that problem. Then the range of multiples then obviously must be very different for that kind of analysis.
Chuck: The other thing that I could see as being an issue here is the quality of the financial data that you’re relying on because we’re talking about a universe of pretty much small businesses here, and it seems like there must be a wide variety in terms of the quality of their bookkeeping and not all small businesses have a need for an audit or even using outside accounting firm to keep their books. Isn’t that right? Do you kind of have to do a mini audit before you can even start?
Neil: The quality of the financial the information does dramatically vary not only by size of businesses, larger businesses, as a rule of thumb are going to have much better quality of data, but as well as just even within the same size of businesses, sometimes you just have a Schedule C to work with and the individual’s personal tax return and there is no balance sheet. It becomes real problematic. We have to sometimes recreate the financial records. We don’t audit them in the technical sense that way, but we definitely have to recreate at least five years of financial data to have any way of being able to assess this company’s performance.
Ed: Thinking about the types of appraisals, I’ve seen a value for an estate or gift tax purposes where the valuation individual knows that person’s going to be on the stand before a jury. That report is attached to a gift or estate tax return, which is being signed under penalties of perjury. It gets a little testy in terms of what is the real approach. I take it, you may have to be prepared to respond to an attorney on the other side questions as to how you arrived at that value. It seems like it’s very subjective. Am I missing something, Chuck, here?
Chuck: Well, yes you sound like the attorney on the other side. Claiming that this is all very subjective.
Ed: I’m thinking you guys, maybe you have done appraisals for the government. That’s okay with me, but typically we’re involved in the other side, questioning the government’s appraised value and that individual who does the appraisal work. They’re at a bit of a disadvantage because they can’t charge very much and they don’t necessarily do a super deluxe job. Is that fair to say that when you’re talking about something that’s going to be attached to return under penalties of perjury, and you know you may be on the stand, does it make your job just a little more difficult or any?
Neil: We express it this way, Ed. We can do what we call full scope valuations and limited scope valuations. Full scope is always when you have either a tax valuation like for an estate or gift, you got to do full scope, or for litigation. When you’re in those arenas, you got to do a full scope. A lot of times when the owner just wants, like I mentioned, if he just wants this for planning purposes, then we do a limited scope where we limit our procedures, we keep the costs down, and I don’t have to sign some sort of certification that we did everything.
Chuck: There was a tax case. I wish I could remember where in the various courts this occurred. It was in the last couple of years, that it involved a gift that an executive of a publicly-traded company made of company stock. That gift tax return got audited by the IRS because after the gift occurred, the company announced that it had a merger or acquisition that was in the works at the time this gift was made, that the executive knew about, but it was not public knowledge. The decision came down that that information, that nonpublic information, notwithstanding the fact that there was a public market for this stock, that the real value of this gift had to incorporate that knowledge of what was happening in the future. That’s one thing we haven’t talked about yet today is future events that perhaps management of a company knows about or anticipates, keeping in mind, of course, that none of these things are certain. It seems like, to me, that would be one of the most difficult things for you to– Are you always just looking backwards when you’re looking at the books that are already closed, or are you trying to price in the events that are on the horizon or contracts that have been signed that might change the financial dynamics of a business?
Glen: That’s a good question. The buzzwords are, it’s facts that are known or knowable as of the valuation date. It’s primarily, you could say looking backwards, but ultimately we do want to get a sense for management about what’s their projections. Valuation is ultimately really a prophecy of the future actually, and so next year’s cash flows a lot more important than last year’s cash flow because that’s the one that’s going to service the debt or provide my rate of return. Yes, subsequent events that happened shortly after somebody passes away can really be sticking points, and the IRS or whoever can certainly challenge that.
Chuck: This was a fascinating case because it’s supposed to be what the arms-length price would be between a willing buyer and seller armed with all the relevant facts. Well, in this particular case with a publicly-traded company, nobody who had that relevant knowledge could legally have traded the stock. The IRS came in and said, “Well, that doesn’t matter. We’re going to pretend that there was a different market where that kind of trading could occur in price it accordingly.”
Ed: Yes. Chuck, you introduce an interesting requirement, I’ll call it. My view, for whatever it’s worth, if we’re talking about a transaction that is under penalties of perjury, a gift tax return, I can assure you that before that valuation is public, it’s incumbent upon the individual. Who’s going to try the case, whether it’s tax court or district court, to sit down with those individuals and the staff, and go through the questions and answers that would be posed if that person were on the stand. I’m talking about big values where you’re talking about X millions of dollars in significant tax involved. When I’ve seen these valuation reports put on the table, without that information, that addresses that very issue, is what’s going on here? That valuation must know a lot about the business. How do you get to know all about the business? You’re challenging that client who is paying your bill, you’re calling him a bit of a turkey, now you’re telling me everything you know. Is that a sensitive issue guys? Who wants to answer that one?
Neil: We keep saying those are good questions, that’s a hard question. Yes, that happens once in a while. A lot of our valuation work is done in a sense for, I’ll call it, non-clients. There are people by reputation who’ve heard our firm does valuations, like a case of an estate, so they come to us. That’s not so much difficult there, but in the case of an existing client, everybody has the expectations of what they think their business is worth. A lot of times their values are what I call sentimental value. When you tell them what fair market value is, which really means what would the marketplace assess the value of business, that can be a rude shock sometimes. The conversations have to happen because that’s what our job is, but it’s not fun.
Chuck: Have you ever had to terminate an engagement just because you weren’t getting the kind of cooperation you were needing in order to be sure you had an accurate work credit?
Neil: That’s pretty rare, mainly because–
Ed: They are existing clients typically.
Neil: Yes, and if they want evaluation, it’s important enough to them that they usually follow through that. That happens, Chuck, in the divorce cases when you’re working on the outside for the non-owner spouse, and there’s a lot of times we don’t get cooperation, and a few times I’ve had to go back to the attorneys in the court and say, “I can’t finish the job.”
Chuck: We’ve had a few times where it’s been kind of tough to get the information we need.
Ed: Kind of tough?
Chuck: For an estate tax return, for instance, where you’ve got a non-public company, but the dissident did not own a controlling interest. You’ve got completely different people who have the books of the company and they’re not really accustomed to just opening up their books to a minority shareholder.
Ed: Chuck, has there ever been a situation we haven’t had a problem? It seems to me whenever we were talking about a minority owner, that is always a problem getting the information.
Chuck: My great segue to my favorite topic, minority interest discounting. Please hold forth.
Ed: Well, before we get to that, I want to go over this recent example and talk about costs. We’re in the process of securing a value, the consultant had valued this business several years ago, we’re using the same group, and the client, one of the siblings said, “No, this guy will do it free. He’s going to do this value free.” I said, “Well, that’s great because we want to save money.” He suggested, “Well, you know–” I’m a business person, so guess what happened? Chuck, did you see the– I saw the appraisal, it was the craziest thing I’d ever seen. It was free, it wasn’t worth the paper it was written on.
Chuck: One page?
Ed: Well, it was five pages, but there was no issue of minority discounts as a segue into what you just expressed. It was nothing. Putting it another way, you’re going to get what you pay for in this whole area. Let’s talk about these discounts, Chuck.
Chuck: Yes, seems like this comes up an awful lot in our practice, where if someone doesn’t have a minority stake in a business, we’ll create one in order to get that discount, a minority interest discount. Then the issue becomes how steep that discount can be when you have these shareholder agreements that restrict pricing and so forth and stock, how effective they are at, actually, adjudicating that price for evaluation purposes and so on. I’m really eager to hear about this topic from your standpoint.
Glen: It’s definitely a big part of gifts and estate tax evaluation. We do them, as you said, to maybe create minority interests, which then can create these marketability discounts. The essence of it is, I like to think on simple terms. Do I want to own 40 acres of land straight up where I can control who the tenant’s going to be and anything about it, or do I want to own a one-fourth interest in 160 acres from somebody else and maybe I don’t have the ability to pay out dividends or control when my exit horizon is going to be? Same thing very much happens in operating companies, which is what Neil and I value, is how attractive is a 25% interest in a privately held company whose stock is not traded on a public exchange? You try to look at different things, principally cash flow, and how much cash flow, not necessarily what the business is going to generate. They may be making a lot of money at the business level, but if I never see that as a minority investor, that’s going to maybe influence how much I’m willing to pay for it and just the risk of how much debt the company has. I just really can’t control my own destiny. That’s where the discount comes up.
Chuck: Do you actually take into account how much has historically been paid out in terms of profit distributions when you’re trying to figure out how much that discounting is going to be for the non-controling stake?
Glen: Yes, for sure, that’s a big factor. If it’s a C corporation, we generally don’t pay out dividends.
Ed: What do you mean by a C corporation?
Glen: A C corporation is an older type corporation. Most of the big companies or a lot of the public companies are still C corporations.
Ed: Wait a minute, that is an Illinois or a Delaware corporation. Why do you say a C corporation? That it files an income tax under subchapter C?
Glen: C, yes.
Ed: Okay. It is a regular corporation, but you’ve added this little footnote to demonstrate how it files its tax return.
Ed: Okay. I’ve never understood people always say, it’s a C corporation or an S corporation. Go ahead.
Glen: For a C corporation, they typically don’t pay out a lot of dividends because there is this double tax problem of a C corporation versus if it’s an S corporation, or it’s flow-through taxation, there is just one layer of taxes and you end up probably getting more distributions paid out. It’s just a factor that you got to consider in looking at a business.
Ed: Is it possible to be taxed on profit and not get cash?
Glen: Very much.
Ed: Isn’t that an issue?
Glen: Oh, yes.
Ed: That’s one of those flow through organizations where it’s a partnership. In other words, where the organization itself pays little if any, maybe there’s some state tax, but no federal tax, and yet, that minority interest holder can’t control how much cash a person gets.
Glen: Hopefully, you got an operating agreement that’s drafted, that requires a certain amount getting paid out every year. Otherwise, it’s like a capital call really if you think about it. You got to come up with money on your own to pay the IRS.
Ed: Okay, wait a minute. Chuck, do you understand? Let’s assume the four of us have this corporation with a million dollars in profit and none of you like me. All three of you have gobs of money and I don’t have. Being Polish, I don’t have any money. You guys say, “Look, we are going to hold this money in and we’ve other sources of income to come up and pay this tax on $250,000.” I’m sitting there, and you say go blow your nose. What is my value if you’re valuing that this is my interest? Is it zero? Matter of fact, it’s a liability, isn’t it?
Chuck: It could be.
Neil: The value there is, that’s where we go to what we call a big discount
Glen: Technical term.
Neil: A big discount from your pro rata share of the whole because as you’re getting stuck every year with a tax liability and no cash to pay up for the company, so that’s not marketable.
Ed: As a matter of fact it creates a liability, right, Chuck?
Chuck: Yes, and we’ve seen that.
Glen: I think you can go to an attorney and under a certain dissenting in shareholder rights, I think there is provisions about maybe how to protect the minority, but it requires a lot of costs.
Ed: Chuck, I don’t know about that. Forcing distributions, you can do a lot of things, but maybe not. I don’t have the slightest idea.
Chuck: Yes, I’m always a little nervous when we get into conversations about what rights are minority shareholder can actually enforce. It always looks good on paper, but in the absence of someone really reaching a fiduciary obligation–
Ed: What do you mean by that?
Chuck: Well, the controlling shareholders and the directors of the corporation have a fiduciary obligation to minority shareholders to run the business in the interest of the shareholders and not engage in self-dealing or self-aggrandizing.
Ed: Wait a minute, the example I gave you. You guys just don’t like me, and you are not taking distributions. I’m not either, I don’t get any, and I’m yelling and screaming. What recourse do I have?
Chuck: I’m not sure you would in that situation. It would be a tough one because it’d be very different if you had, let’s say, the other three were all employees, for instance, and then they were taking excessive salaries. They had salaries that they were paying themselves enough that it was enough to pay their tax obligations resulting from also being shareholders, but then they left you out to dry. That would at least be a little closer because there’s some self-dealing going on, but if it’s just, “Hey, we’re all in the same boat,” and you don’t like the decision, with those bare facts, that doesn’t strike me as a cause of action-
Ed: Yes, you guys just tell me to go blow my nose, and whatever.
Chuck: Right. Sell your shares, I’ll buy them.
Ed: Okay, for how much?
Chuck: How about these guys appraise the very big discount on your shares.
Ed: It seems to me that i’m willing to give them up because I’m not going to have the recurring liability. Is it fair to say the takeaway, the lessons, the main lessons in value it’s really in the eye of the beholder, what’s the purpose, and what side are you, what’s the nature of the judgment you’re bringing to the table, what’s really going on in this business? What else you have to consider in an overview fashion? Putting it another way, why would you ever want to do this work?
Neil: It’s fun.
Ed: It’s fun.
Neil: We love learning about businesses and what makes them tick and successful. I would suggest the most common misunderstood issue when we’re doing business valuations from the owners is they come to us and they say, “Can you tell me the value of my business?” The question is, what do you mean by your business? All these multiples, market price multiples and stuff we talked about, the question is, what’s included in that, in that value? In the case of a business, does that mean– Let me give you examples. Does that include the cash for the business? Does that include the working capital of the business? It’s almost always going to include the equipment and the intangible value, but whether or not it includes working capital, whether it includes cash, are there any liabilities?
Ed: What about the goodwill? Charlie owns the widget company, and he’s the guy that designed it.
Neil: Yes, who owns the goodwill?
Ed: Is that an asset that’s being sold?
Neil: Yes. That’s the thing that we have to sort out that so many times in a merger and acquisition deal, the buyers and the sellers think they have some informal agreement, and then they discover one was talking about, “Well, I’m buying the Chevy,” and the other guy is thinking he’s selling a Mercedes, and it falls apart. You got to know what’s included in the value of the business.
Ed: Glen, it seems to me that the only thing constant here is change. Let me ask you a couple of questions. Would you still be doing this if you weren’t getting paid to do this?
Glen: I think I would really. If you had some other means to pay the bills. It is fun, as Neil said. You learn about industries and not just financial things but non-financial measures, and just what are the little things that make this business special, talking to different people, and it’s really pretty fun. Very successful people usually. It’s fun.
Ed: Neil, a second question. How much would you pay to be allowed to do this?
Neil: Value your business but in reverse.
Ed: What would you pay to be able to do what you’re doing?
Neil: For my own life, this is at the top of my work desires and loves. I really like to do this. If I’m going to pay to work, then I’m going to pay to do this. How much would I pay?
Ed: No, but the point is it seems to me, gentlemen, that you’re fairly passionate about what you’re doing. Is that fair?
Chuck: Yes, I don’t do what they’re doing, but I understand the sentiment.
Ed: That’s impressive. Any other questions? Any questions I haven’t asked you that you think I should have asked you?
Neil: Well, the only other question maybe I can think of right now is, how has COVID affected business valuations?
Ed: Yes. That’s a super question. We have black swans all the time, so to speak, and so do you factor in black swans? I don’t know. That’s why I wouldn’t want to do your business, so to speak. I would rather drive a cab.
Chuck: Are you finding that deals are slowing down because of this?
Neil: They slowed down during the summer months, April, but they’re starting to pick back up now. Yes, and how has COVID affected that? There’s no question during the shutdowns and stuff for many businesses industry, it did have a negative effect. The real question in valuation, though, is what’s going to be the long term effect on this particular business or industry? As Glen said, valuation is forward-looking, in the sense that you want to know how is this business going to do in the future. That’s where the COVID becomes a dilemma.
Ed: Well, Neil there’s one observation we’ve talked about, we’ve said that lawyers tell you what you can’t do, accountants typically tell you what you’ve done. You folks are in a position being an entrepreneur really saying, “What’s going to happen in the future based upon what I can see?” That’s a little upside down in traditional accounting engagement. Is that fair?
Neil: That’s correct, and that’s why I love doing this because I like being a non-traditional accountant.
Ed: Chuck, any other questions?
Chuck: No, I think we covered it.
Ed: Gentlemen, thanks for your time and effort, and until you’re better paid, thanks for your time.
Neil: Thank you, gentlemen.
Glen: Thank you.
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