Step 8 to Reviewing a Business Valuation Report – Income Taxes

Income tax considerations are vital to conducting a proper business valuation.  Step 8 to reviewing a business valuation report involves ensuring the value conclusion incorporates the relevant income tax considerations.

The value of an operating business is dependent on its ability to generate discretionary after-tax cash flows.  In cases where business value is driven by the underlying asset values, such as real estate holding companies, important income tax considerations must also be taken into consideration.

 

Some of the relevant income tax considerations applicable in the valuation of operating companies and real estate holding companies are discussed below:

Operating Companies

Under a cash flow based valuation approach (e.g. CCF or DCF), the following tax considerations should be addressed:

1. Cash flow and cap rate consistency – after-tax discretionary cash flows should be capitalized by after-tax cap rates
 
2. Redundant assets – should be valued net of corporate income taxes (i.e. net realizable value) and added to the value of the business operations otherwise determined


3. Tangible asset backing – should reflect the value of the capital cost allowance tax shield inherent in capital asset values that would not be available to an acquirer of shares (i.e. the tax shield foregone)


4. Existing tax balances – the present value of future tax savings that may arise from existing tax pools generally represents incremental value assuming the buyer is a taxable entity. [1]  In Canada, existing tax balances can include the following:

Undepreciated capital cost (UCC) and cumulative eligible capital (CEC) balances;
Non or net capital tax loss carry forward (LCF) balances;
Unused investment tax credit (ITC) balances;
Refundable dividend taxes on hand (RDTOH) balance; and
Capital dividend account (CDA) balance.

It is beyond the scope of this article to discuss each of these tax balances in detail.  In reviewing a valuation report, however, you should review the company’s corporate income tax returns to identify whether any of the above noted tax pools existed as at the valuation date. 

 

Real Estate Holding Companies
 

Real estate holding companies are typically valued using an adjusted book value approach.  An important tax consideration in valuing the shares of a real estate holding company is the real estate valuation adjustment (REVA).

 

In a share valuation, the REVA represents the estimated discount a potential purchaser would require as compensation for the disposition costs (e.g. sales commissions, legal fees and income taxes) that would be incurred on an ultimate sale of the underlying real estate assets at fair market value.  The income tax costs are sometimes referred to as built-in tax costs. 
 

In Canada, there is no formally agreed upon position with respect to the treatment of built-in tax costs. [2]  Options for treatment include:

Full recognition
No recognition
Partial recognition

The arguments for full recognition and no recognition will not be discussed herein. With respect to partial recognition, the following options can be considered:

Calculate the disposition costs on an assumed immediate sale of the real estate and take a discount (e.g. 50%) to reflect the uncertainty associated with the timing of a future disposition (i.e. to reflect the present value);
Calculate the present value of the disposition costs based on an assumed holding period (e.g. 5, 10 years) that is reasonable under the circumstances and reflects the intentions of the potential purchasers; or
Take the mid-point of the following two extremes:

1. Immediate disposition: calculate the disposition costs based on an immediate sale; and
2. Perpetual hold: calculate the lost tax benefit to the purchaser assuming the underlying properties will never be disposed of (i.e. foregone tax shield).  In the case of a perpetual hold, the purchaser’s only disadvantage would be the tax shield foregone by virtue of acquiring the shares of the company as opposed to the assets directly and being able to bump up the cost base of the land and building to their fair market value for tax purposes.  By not being able to bump up the cost base of the land and building to their fair market value for tax purposes the purchaser has lost the ability to write off depreciation for tax purposes (i.e. capital cost allowance) on the higher tax bases. 

Income tax considerations are integral to preparing an accurate valuation and should be a major focus in reviewing a business valuation report.  If you have any questions with respect to income taxes in conducting a business valuation, contact us at www.vspltd.ca.

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1.  This is not the case when valuing net assets as existing tax pools do not flow to the acquirer in an asset purchase.
2.  Source: Financial Principles of Family Law, Freedman, Loomer, Alterman, White, page 22-1, 22-6.


     

Step 7 to Reviewing a Business Valuation Report – Redundant Assets

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.

Will You Maximize Value with a Superstar Sales Rep?

Do you need a superstar sales rep to build your business for a successful transition?

Actually, you should avoid the trap of relying on one superstar sales rep if you want to maximize the value of your business.  To maximize value, a seller must be confident that the company will continue to generate sales after you are gone.  Many business owners think that hiring one superstar salesperson to replace themselves as a rainmaker is the answer.  Doing so, however, may simply trade a dependence on you to dependence on a sales rep.  Your business will be no more salable as a result.

According to the researchers at the "Sellability Score", businesses that could easily replace their top salesperson were more than twice as likely to get an offer to buy their business than those companies who are overly reliant on a single salesperson. [1]

To maximize value you need a sales team – not just a single salesperson.  Hiring a single sales rep will only keep your business reliant on one person.  How do you build an entire sales team?  Here are four tips for building a sales team on a budget:

1.  Start charging up front

Sales reps can be expensive to find and train.  In order to avoid running out of cash before they are fully ramped up, consider charging some or all of your fees up front by way of retainer, deposit or advance.  If you stagger your billing, ask for a larger portion up front.  If half your customers agree to the larger deposit, you’ll have more cash to build your sales team.

If possible, consider a subscription or service contract model as most people are used to paying for subscriptions up front.  If you can lock customers into an annual contract try offering an incentive for full payment in advance.  For example, if you charge $1,000/month for a maintenance contract but offered clients an option to pay $10,000/year up front, you would have $10,000 in the bank for each contract sold.  If a new sale rep could sell two contracts per month, you should be able to cover their monthly costs in no time.

2.  Carve territory into small chunks

 

Sales territory is an asset which is easy to offer to sales reps but hard to take back.  You should carve up your market into sales territories that provide enough opportunity for each sales rep to make money.  Don’t be afraid to leave a territory unfilled for years.  Avoid the temptation to allocate all sales territories to existing sales reps as it will become impossible to take back certain territories when you’re ready to hire a new sales rep.

3.  Hire a second rep as quickly as possible

If possible, start by hiring two sales people, not just one.  Sales people thrive on competition, and in order to have a salable company, you need to be able to demonstrate to a buyer that your sales are driven by a sales team and not just one high performing salesperson.  If you’re charging up front or on a subscription model, you should be able to quickly get to the point where each sales rep is at least covering their costs to you.

4.  Think long-term

 

Good salespeople are are difficult and expensive to find.  Once you have a good salesperson, the benefits associated with investing in retaining that salesperson more than outweigh the costs associated with finding and training a replacement.  Two things to consider in this regard include: employment contracts with appropriate clauses (e.g. non-competes); and compensation packages that provide long-term financial incentives to stay with the company (i.e. more than an annual bonus).  HR consulting firms and employment lawyers can assist in this regard.

Replacing yourself as the company’s rainmaker is the right strategy if you want to maximize the value of your business; but avoid trading a dependency on you to dependence on one superstar sales rep.  Focus on hiring and retaining a quality sales team and watch your company and its value grow exponentially.

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[1] The Sellability Score is an online questionnaire that allows a business owner to assess the "sellability" of the company. If this is of interest, you can find out your company’s Sellability Score:

http://sellabilityscore.com/vsp/jason-kwiatkowski.

Video Segments - What Business Owners Need to Know

All business owners will one day sell their business.  For those that are prepared this will occur voluntarily, on their terms at a time of their choosing.  For many business owners, however, this will occur involuntarily due to burnout, illness, disability, divorce or death.

 

Are you looking to sell your business within the next five years?  If so, the time to act is now.  You and your business need ample time to prepare for this event – and there are things business owners need to know before even contemplating selling their business.

 

You may turn to your accountant or lawyer for advice regarding exit or succession planning, but have you involved an independent financial planner, business valuator or corporate finance specialist in your exit planning discussions?

 

Financial planner	Vital to ensure you achieve your financial needs and goals
Business valuator	Vital for estate planning, enhancing value and avoiding legal disputes
Corporate finance specialist	Vital to increase the salability of your business and to find a buyer

 

These professionals are critical to developing an effective exit plan; one that will ensure your goals are met when you sell or exit your business on your terms at a time of your choosing.

 

If you are interested in learning more about the importance of these professionals to your exit planning efforts, check out this series of short videos that deal with what business owners need to know before even contemplating selling their business.

 

CLICK HERE: What Business Owners Need To Know

 

Video 1 – In this video segment, Scott Plaskett, Senior Financial Planner and CEO at Ironshield Financial Planners (www.ironshield.ca) discusses why traditional financial planning for business owners does not work, the most common trap business owners set for themselves and how to get your business ready for your retirement.

 

Video 2 – In this video segment, Scott Plaskett interviews Jason Kwiatkowski, CA, CBV, ASA, CEPA and President at Valuation Support Partners (www.vspltd.ca) about why you need to know what your business is worth today, a major trend that should concern business owners and why the last 3 to 5 years of your business are so critical to your success.

 

Video 3 – In this video segment, Scott Plaskett interviews John Duguid and Rod Howland, Managing Directors at Gallium Corporate Finance (www.galliumcf.com) about what all buyers care about (and no it’s not price), what a traditional sales cycle looks like and the best and worst time to sell your business.

 

You may not be looking to exit your business in the coming year.  However, if you are planning to exit within the coming decade and would like to maximize the price you receive, you must begin your planning now.  Contact us at www.vspltd.ca to help you get started and to work with you to ensure a successful implementation.

 

 

 

 

Step 6 to Reviewing a Valuation Report – Discount Rate Reasonableness

Is the valuation based on a going concern income-based approach such as a discounted cash flow approach (DCF) or capitalized cash flow approach (CCF)?  If so, what discount rates or capitalization rates are the value conclusions based upon?

Step 6 to reviewing a business valuation report involves assessing the reasonableness of the selected discount rates or capitalization rates (or "cap rates").

Although discount rates and cap rates are related terms, they are not interchangeable.  For clarification, each of these terms is discussed briefly below:

Discount Rate

A discount rate is the rate of return used to convert a monetary sum or series of future anticipated cash flows into a present value. [1]

A discount rate is used in a DCF approach to convert the discretionary cash flows forecasted over a projection period to a lump sum present value.  The discount rate is a function of the perceived risk associated with the business actually achieving the projected cash flows in comparison to the return on a benchmark ‘risk-free’ stream of cash flows. [2]

Capitalization Rate

A cap rate represents the rate of return used to convert a uniform (or constant) stream of future cash flows into a lump sum present value.  The inverse of the cap rate is referred to as the multiple or multiplier. [1]

A cap rate is used in a CCF approach to convert the estimated annual maintainable discretionary cash flows to a lump sum present value.  There is an inherent assumption that the annual maintainable cash flows will be generated to perpetuity.  The cap rate is derived when a growth factor is deducted from the discount rate.  The growth factor can be comprised of expected long term inflation and an incremental real rate of growth. [2]

Discount rates and cap rates are usually expressed as either a weighted average cost of capital ("WACC") or as a levered return on equity.  WACC is applied to discretionary cash flows before debt service costs to arrive at a company’s enterprise value.  The levered return on equity is applied to discretionary cash flows after debt service costs to arrive at an equity value directly.

The reasonableness of the discount rate and/or cap rate assumptions can significantly affect the integrity of the resulting value conclusions.  The business valuator must select and appropriately apply discount rates and cap rates that he/she believes accurately reflect the risk associated with the target company being able to achieve the future cash flows.  This risk assessment is an area where judgment is required and is often a common area in which valuators (and potential purchasers for a particular business interest) will differ.

The following principles should be followed when deriving and applying discount rates and cap rates:

Discretionary cash flows – discount/cap rates should be applied to cash flows after taxes, capital investment and incremental working capital needs
Internal consistency between the discount/cap rates and the cash flows – areas for consistency include pre-tax versus after-tax, inflation assumptions and real growth considerations
Risk and return tradeoff – all other things equal, the more aggressive or optimistic the cash flow projections the higher the discount rate should be
Operating and financial risk – discount/cap rates should consider both operating risk (risk that the projected unlevered cash flows will not materialize) and financial risk (incremental risk assumed by equity holders resulting from the use of debt financing)
Market rates of return – required rates of return are influenced by the prevailing general market rates of return and anticipated changes in market rates at the time

The above noted areas should be considered when reviewing a business valuation report to assess the reasonableness of the discount/cap rates adopted by the business valuator.

Reasonable and supportable discount rate or cap rate assumptions 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 significantly.  As a result, assessing the reasonableness of the discount/cap rates should be a major focus in reviewing a business valuation report.

If you have any questions regarding assessing the reasonableness of discount or cap rate assumptions 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: Canada Valuation Service, Ian R. Campbell, Howard E. Johnson, H Christopher Nobes, 2010.

2.  Source: The Valuation of Business Interest, Ian R. Campbell, Howard E. Johnson, 2001.

Step 5 to Reviewing a Valuation Report – Cash Flow Reasonableness

Is the valuation based on a going concern income-based approach?  If so, what future cash flow assumptions are the value conclusions based upon?

 

The reasonableness of the underlying cash flow assumptions can significantly affect the integrity of the resulting value conclusions.  Under common income-based valuation approaches, the business valuator must select an operating cash flow level (or range) that he/she expects the business to generate going forward.  The cash flows may vary from year to year over a specific projection period or an ongoing maintainable level may be assumed.

 

Step 5 to reviewing a business valuation report involves assessing the reasonableness of the projected cash flow assumptions. 

 

Income-Based Approach

To recap, an income-based approach involves estimating the present value of the projected future cash flows to be generated from the business and theoretically available to the capital providers of the company.  A discount rate is then applied to the projected future cash flows to arrive at a present value. 

 

Two common income-based approaches include the discounted cash flow (DCF) approach and the capitalized cash flow (CCF) approach.  A brief discussion of each approach along with some key items to consider in assessing the reasonableness of the projected cash flow assumptions is set out below:

Discounted Cash Flow Approach (DCF)

 

The DCF approach involves estimating the present value of the projected future cash flows to be generated from the business.  A discount rate is applied to the projected future cash flows to arrive at a present value.  The cash flows are typically projected over a limited number of years (e.g. 3 to 5 years) and a terminal value is determined as at the end of the projection period based on an assumed annual cash flow at that time.

 

Items to consider in assessing the reasonableness of the projected cash flows include:

 
Time period – a longer period is more difficult to accurately predict
Revenue growth rates – supported by actual historical rates and/or industry averages?
Gross profit margins – consistent with past performance and/or industry averages?
EBITDA margins – consistent with past performance and/or industry averages?
Capital reinvestment – sufficient to meet revenue and cash flow growth? 
Working capital requirements – often overlooked but necessary to support revenue growth

Where cash flow projections are provided by management, the valuator should assess the reliability of management’s projections including the ability of management to accurately predict future cash flows.  This can be done by comparing actual historical results to management’s original projections for the same period of time.

 

Capitalized Cash Flow Approach (CCF)

 

The CCF approach involves converting an annual maintainable cash flow (e.g. discretionary cash flow, EBITDA, etc.) into a lump sum present value using a capitalization rate (or valuation multiplier) that reflects the risk profile and long-term growth prospects of the company.  Under this approach, historical results serve as a proxy for the company’s future performance.  As a result, the valuator must "normalize" the company’s historical cash flows so they provide the best representation of what the company is expected to generate going forward.

 

Items to consider in assessing the reasonableness of the projected annual maintainable cash flows include:

Normalization items - have all normalization items been considered and appropriately reflected?
Trends – has there been an increasing/decreasing trend in the past normalized cash flows?
Past as an indicator – is the past truly representative of the company’s future?
Weighting – should certain years be more heavily weighted than others?
Changes – have there been recent changes in business strategy, product mix, customers, contracts, suppliers, employees, etc.?

Some of the more common normalization adjustments you can expect to see include:

Shareholder remuneration – should be adjusted to market wages for services provided
Related party payments (e.g. wages, rent, etc.) – should be adjusted or imputed to market amounts for services provided
Personal and/or discretionary expenses - should be added back
Non-operating income – income from redundant assets should be deducted
One-time, non-recurring items – revenues should be deducted and expenses should be added back 

 

Reasonable and supportable future cash flow assumptions 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 significantly.  As a result, assessing the reasonableness of the projected future cash flows or the normalized historical cash flows and resulting selection of maintainable cash flow should be a major focus in reviewing a business valuation report. 

 

If you have any questions regarding assessing the reasonableness of cash flow assumptions 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.

Step 4 to Reviewing a Valuation Report - Valuation Approach

How many different valuation approaches are there?  How does a valuator select which valuation approach to apply?  What if the valuator adopted an incorrect valuation approach?

 

The business valuator is responsible for selecting an appropriate valuation approach and for ensuring that it has been correctly applied.  Step 4 to reviewing a business valuation report involves identifying and assessing the valuation approach adopted by the valuator. 

 

In valuing a business, there are many valuation approaches to select from.  In the context of a legal dispute,

"There are many ways to approach an analysis of a loss resulting from a particular set of facts. Part of the expert’s role is to identify all of these alternatives and determine which is the most appropriate." [1]

 

There are two fundamental bases on which to determine the value of a business: going-concern and liquidation.  In the case of a company that is expected to continue operating well into the future, the prospective investor will evaluate the risks and expected returns of the investment on a going-concern basis.  If for any reason the company is likely or expected to liquidate, liquidation values for the assets, as well as costs associated with liquidation would prevail.

 

All methodologies applied to the valuation of business may be broadly classified into the asset-based, income-based or market-based approaches.  Each of these is discussed briefly below.

 

Asset-Based Approach

 

The asset-based approach is applicable when the underlying asset values constitute the prime determinant of corporate worth.  The application of this approach depends on the nature of the company’s operations (such as an investment or real estate holding company) and/or if the outlook for a particular company’s earnings is somewhat uncertain, or returns based on earnings are insufficient to justify the investment in assets.

 

This approach focuses on individual asset and liability values from the company’s balance sheet, which are adjusted from book values to fair market values.  The asset-based approach can also be applied in situations where liquidation is likely or expected.

 

Income-Based Approach

 

The income-based approach involves estimating the present value of the projected future cash flows to be generated from the business and theoretically available to the capital providers of the company.  In general, a discount rate is applied to the projected future cash flows to arrive at a present value.  The discount rate is intended to reflect all risks of ownership and the associated risks of realizing the stream of projected future cash flows.  It can also be interpreted as the rate of return that would be required by providers of capital to the company to compensate them for the time value of their money, as well as the risk inherent in the particular investment.

 

There are different variations of the income approach.  Common income approaches include the capitalized earnings ("CE"), capitalized cash flow ("CCF"), excess earnings ("EE") and discounted cash flow ("DCF") approaches.  An income-based approach is typically the most common valuation approach adopted in the valuation of privately held operating companies.

 

Market-Based Approach

The market-based approach involves comparing the subject business to similar "guideline" companies whose securities are actively traded in public markets or which have recently been sold in a private transaction.  Certain valuation metrics (e.g. EV/EBITDA, EV/Sales, etc.) obtained from a sample of comparable public companies and/or industry transactions are applied to the subject business to arrive at a value range.  This approach is generally appropriate when the subject business is publicly traded and may also be useful for indicating what a privately held business would be worth in the public market.

 

It is dangerous, however, to blindly apply a market-based approach to a privately held company without carefully assessing the comparability of the target business to the "guideline" companies.  Certain adjustments may be required to the public company and/or industry transaction multiples (e.g. to account for differences in size, growth, control, marketability, etc.) before they can be applied to the target business.  In addition, it is very difficult if not impossible to assess the extent to which purchaser perceived synergies, relative bargaining abilities and emotional considerations influenced the price realized in an actual industry transaction. 

 

As a result, a market-based approach may not be appropriate as a primary valuation approach.  It can, however, be useful as a reasonableness check on the value otherwise determined under an income-based approach.

 

It is the valuator’s role to determine which approach is appropriate in light of the company-specific facts and circumstances and the valuator should adequately explain and justify the reasons for his/her selection. 

 

In reviewing the valuation report, the following questions should be addressed:

1. What valuation approach was adopted?
2. Is the valuation approach appropriate under the circumstances?
3. Would an alternate valuation approach be more suitable?
4. What would be the impact if a more suitable valuation approach was applied? 
5. Would adopting an alternate valuation approach corroborate or refute the values determined under a primary approach?

In my experience, business valuators will typically agree on an appropriate valuation approach.  It is the application of the approach and/or the underlying assumptions where valuators will often differ.  However, identifying and understanding the valuation approach adopted is critical to an effective review of a valuation report.

 

If you have any questions regarding matters involving the valuation of your business 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.  The Litigator's Guide to Expert Witnesses, Mark J. Freiman and Mark L. Berenblut, p. 87.