Does the company own assets that are not integral to the business operations or required to generate revenues? If so, have these assets been appropriately reflected in the valuation of the business?
Step 7 to reviewing a business valuation report involves identifying any redundant assets the business owns and ensuring they have been valued separately and added to the value of the business operations otherwise determined.
Redundant Assets
Redundant assets are defined as tangible and identifiable intangible assets that are not required by a business to generate the operating cash flows as projected. Where redundant assets exist, their value (typically net realizable value) is added to the going concern value of the shares or net assets of the business determined pursuant to a cash flow based or other valuation methodology. [1]
It is typically assumed for purposes of a notional valuation that a prudent vendor would either extract such redundant assets from the business prior to the sale, or require compensation from the purchaser for the net realizable value of the redundant assets. In this context, net realizable value generally refers to the market value of the redundant assets less the disposition costs (i.e. sales commissions, legal fees, etc.) and income taxes that would be incurred on the sale at the corporate level.
Identifying Redundant Assets
Identifying redundant assets requires a careful review of the company’s balance sheet as at the Valuation Date. Each asset and liability should be segregated into "non-operating" and "operating" categories. Operating assets and liabilities form part of the company’s tangible asset backing, whereas non-operating assets form part of the company’s redundant assets.
The existence of redundant assets will depend upon the nature of the business operations and the owners’ preferences for leaving non-operating assets in the business or extracting them through salaries, dividends, etc. Working capital (e.g. cash, accounts receivable, accounts payable, etc.) and capital assets are common operating assets for most businesses. Common redundant assets to be aware of as you review a company’s balance sheet include:
- marketable securities;
- investments in other businesses;
- investments in real estate
- excess equipment or other capital assets such as personal automobiles;
- life insurance policies;
- advances to or from related parties; and
- related party loans.
Redundant assets may also be hidden in the form of excess cash or excess working capital. A careful analysis as to an appropriate working capital level is critical to identifying this hidden redundancy as excess working capital should be reflected as value over and above the value of the business operations. If the company has interest-bearing debt or debt equivalents, cash is generally treated as a redundant asset or as an offset to the interest-bearing debt.
If the company owns real estate (i.e. land and/or building), you should determine if the real estate is: a) being used by the business; b) being leased out to another party; or c) vacant and being held for resale. This can be a tricky area and valuators may disagree on how the real estate should be treated. As a general rule, however, real estate should be treated as a redundant asset, valued separately from the business (e.g. through an independent real estate appraisal) and added to the value of the operations.
If the real estate is not actively used in the business operations, valuators will typically agree that the real estate should be considered redundant. On occasion, however, the business may own the land and building that it operates from. Some valuators may argue that because the assets are being actively used in operations they are not redundant and should be included in the company’s tangible asset backing (i.e. the net tangible operating assets). However, it is often argued that real estate assets and business operations should be valued separately because the expected rates of return on real estate are generally different than the expected rates of return on business operations (e.g. risk profiles are different).
The identification and valuation of redundant assets, as separate from the business operations, are critical to a reliable value conclusion. Depending upon the scope of review, inquiries and experience level, this is an area where business valuators can differ. As a result, identifying redundant assets should be a major focus in reviewing a business valuation report.
If you have any questions with respect to redundant assets or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.
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1. Source: The Valuation of Business Interests, Ian R. Campbell, Howard E. Johnson, 2001, page 92.
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