Looking for Help from Small Business Owners (Vanity)

Alberta's Child | 10/15/03 | self

[Alberta's Child]

Sory for the vanity post, but I've found in the past that folks here can provide a wealth of valuable information . . .

I'm looking for some help from a Freeper who is the sole owner or a partner in a professional consulting business of any kind (accounting, law, engineering, etc.). I have been given the opportunity to secure a partnership in a firm, but I am having a difficult time assessing the value of the company to determine if this is a worthwhile endeavor.

I have been given access to five years worth of financial statements, and I trust the existing partners implicitly in most matters. We have reached a difficult point in the negotiations, and based on previous experience I suspect that they may be getting poor legal/accounting advice in this matter.

I've used a number of different methods (and my own professional advisor) to do this assessment, and it is clear to me that these methods can yield a wide range of estimated values for a small company. The major item of contention here is that the method used by the company's legal/accounting advisors to compute the value appears to be more suited to a large, stable company with a proven track record than a smaller one with a lot of growth potential but a limited track record.

Has anyone here gone through a similar process in the last few years? What are some of the key measures that you used to make a similar assessment?

Thanks in advance for any help that might be offered here!

[expatpat]

This probably isn't what you're looking for, but valuation of a company is always a very uncertain process. One approach is to add up the profits expected for the next 3-5 years, then use the final year's as an estimate of the longer-term out-years (flat) profits, use discounted cash-flow on those, and add the two pieces together to get the total value.

Again, tho', it's nowhere near being a science. Big companies use 50% of sales, but that probably wouldn't work for a small company, as you suggest.

[Alberta's Child]

50% of sales was a rough "rule of thumb" that I used as a starting point in this process. The problem is that old accounts receivable are included in the value -- and due to the nature of our work (for some of our projects the client retains 5% of the fee until the work is complete, which could be a long process) this number is quite substantial.

I suspect that the partners of this firm are operating under the misguided notion that an accurate method for assessing the value of this company is the same method that was used to assess the value of the (much larger) company where they both worked earlier in their careers.

[Held_to_Ransom]

Too vague a question to answer. The real value of most small companies is actually in the people who own and manage them, and not in the rest of the company. This makes it a very fickle investment at best, especially if you think they really don't have a firm grip on their books.

I have an old friend who made a comfortable retirement on buying up bankrupted hardware stores, building them up into profitable businesses because he really had a talent for running them, selling them and then buying them back at bankruptcy a few years later.

Be careful. In most cases, I would submit that you could start your own business at a lower cost, provided it didn't depend on competent and committed partners to run.

[Dave S]

How certain is the earnings flow? What differentiates the firm from others offering the same or simlar services (i.e., why buy from them)? What percentage of the billings and earnings are accounted for by the two one or two clients? How safe is the firm from technological change or impacts of outside forces such as terrorism? (note what happened to the travel industry in one day; similarly look what happened to partners in some of the big accounting firms when a small part of the firm got embroiled in legal trouble) Is the firm's success linked to any one individual and if so what happens to the firm if that person should die, retire, or go to a competitive firm? Good luck.

[Alberta's Child]

The real value of most small companies is actually in the people who own and manage them, and not in the rest of the company.

Exactly. This is why they are looking to bring in a group of partners underneath them -- this is a long-term succession plan.

This makes it a very fickle investment at best, especially if you think they really don't have a firm grip on their books.

It is a "fickle" investment, but I have a better understanding of the firm's finances than either of the partners. I have no concerns in that regard, and I'd be an ideal partner because I have plenty to offer in terms of improving the way we operate. The problem is that at the value they've pegged on this company it makes no sense to buy into it -- I'm having a hard time convincing them that their legal/accounting advisor is advising them poorly.

[JonH]

Small businesses or partnerships are the toughest to value.

The most conservative approach, often used to value stock for buy-back purposes is that share value equals shareholder's equity divided by shares outstanding. This give no value to future income vstreams.

Typically small businesses can be bought for something in the range of three to five times average cash flow from operations over the past three years. Absent some significant cash flow influence (e.g., major capital project, rapid growth, etc.) this is the best measure. If the business is growing rapidly, the price would be at the higher end of the multiple range.

Operating income can be used as an alternative to cash flow at the same multiples. Assuming this is a partnership or "S" Corporation, after tax (net income) is meaningless because of the pass through rules.

No value should be based on "future projections" unless there are contracts in place that would assure achievement. Also, do not accept CPA's "restated" income statements as a basis for value unless you know that the costs that they eliminated are gone forever. Finally, if you join a partnership, answer these two questions; Will you add more revenue than you cost? If not, why do they want you to invest?

[kayak]

No advice to offer but I can bump the thread for you.

[Alberta's Child]

Good questions. We have a pretty diverse client base, so that is not a major concern. A couple of major clients get very close attention not only because we do a lot of work for them, but because they pay their bills in a timely fashion.

The entire industry is fairly "safe" from technological change compared to others -- we are civil engineers, and this discipline is traditionally the most low-tech of engineering disciplines and hasn't really changed very much since the time of Archimedes (LOL).

We actually do very well in a post-terrorism or catastrophic disaster environment -- when the sh!t hits the fan, things need to get built and re-built in a hurry.

The success of the firm is closely tied to the success of one of the few major partners, but his real value is the work environment and culture that he passes down to his employees. That's what all of us prospective junior partners are looking to preserve.

[Alberta's Child]

Thanks for the points. I have no concern about the accuracy of what the CPA has provided, since I am very familiar with our numbers before the CPA gets them (ironically, I'm usually the one who provides them to him!). I do have a very thorough understanding of how this company works from a financial perspective.

[Southack]

Are you buying "good faith" or are you buying real assets?

Real assets are things like office buildings, heavy equipment, and aircraft.

Good faith would include such things as name recognition and existing customer base (because lets face it, customers aren't slaves, they can leave for someone else).

Most buy-ins include some of both real assets and good faith. Discount real assets as if you had to sell them quick for an emergency (say, 15% below their last appraisal). Discount good faith down to the cost that it would require to pay to obtain that same good faith in a brand new business.

With those discounts in hand, know that whatever you offer above that combined price is money that you are admitting to yourself that you could lose if things don't go completely as planned in the future (i.e. your "at risk" value).

Now compare your potential profit/reward if things do go well. You've then got in front of you your potential financial risk versus your expected financial reward.

Armed with that risk-vs-reward, you can then compare your potential new partnership with whatever other investment opportunities are available to you, including stocks and bonds.

I hope that you've seen the tax returns for at least the last two years for the critical partners, too. In this way you can get a feel for how honest (i.e. books versus declared) the numbers are.

If it all looks good and falls within your personal risk comfort zone, then go for it with full speed. Many a proprieter missed joining Sam Walton before he was Wal-Mart. Inaction is a killer.

But if it isn't your best possible investment or doesn't have a comfortable risk level, flee from it.

[razorback-bert]

Sounds like you really know the business and think the price is too high.

[William Tell]

Alberta's Child said: "I'm having a hard time convincing them that their legal/accounting advisor is advising them poorly."

I recently helped my daughter offer three percent below asking price for real estate. Since the sellers had multiple offers, we ended up paying two percent above asking price.

The price we paid was more in line with prices which had been paid for similar properties recently. The local market showed a compound annual growth rate in prices of between 13 and 21 percent for the last five years.

I struggled during the negotiation to find a basis for deciding what the "value" of the property was. Now that the property is in escrow, anyone else will have reason to believe that it is worth exactly what we paid.

Because you are looking at a more unique "property" it is harder to find "comparable" properties with which to compare.

Is there anyone beside yourself in the running for this opportunity or are you the only conceivable buyer? If there was another buyer, what value would that buyer put on the deal? Would he have any reason to value it differently than you do? Would he have any reason to value it the way the "sellers" wish to value it?

Similarly, are there any other "sellers"? Is there another partnership into which you could buy? Would you value such a deal any differently than you are valuing this one? In this alternative partnership, are there any justifications for using the valuation method that you have otherwise found unacceptable?

Of either you or the "sellers", which has the most lattitude in concluding the deal? If you are younger, then you might conceivably wait until another opportunity arrives. If the "sellers" are older, they may not have any latitude. Perhaps they must sell now.

How far apart are the two valuations? Is it possible to identify a mutually acceptable mediator to consider the two methods and to voice a persuasive opinion regarding them?

Your concern makes it appear that the two valuations are quite far apart. Is it at all possible that there are issues that appear to be understood but which might explain the size of the difference? Are there ways to restructure the deal so that the issues which cause the valuation difference can be separately handled or deferred until later? Sometimes the tail can be wagging the dog.

Is there any way to "test drive" the deal? Can you purchase an option on the deal at their price and defer the decision until their argument might be more convincing? Can you "test drive" for eighteen months at your price, with a full refund if not happy, or a payment due of the difference if you are happy.

You mentioned that 5% of some past fees have been retained by customers and that this adds up to an appreciable amount. Perhaps some third-party speculator would buy these future payments at a discounted price now, increasing the likelihood that the partnership collects. Perhaps the "sellers" can separate out some of the retained payments in order to decrease the impact on your decision. The ability to collect these funds would then be of less concern in your valuation.

[William Tell]

Another thought that occurs to me is that sometimes people focus more on differences than similarities. You might benefit if you find a way to communicate to the "sellers" the parts of the deal that you agree on. Also, describe a few of the issues on which you and the sellers disagree the least.

As each of you begins to see more and more agreement, you will each start behaving differently because you have more expectation that a deal will eventually happen.

With work and luck, you may eventually find yourselves with just one remaining issue. Both parties will have great incentive to "give" in order to get the deal done. The "creative juices" really start to flow when each party views a success just around the corner.

As another poster pointed out, deals like this hinge very much on intangible goodwill. You want to reach the finish line with an agreement without destroying any of the goodwill which exists between you and the "sellers".

[Alberta's Child]

Thanks for your posts -- I'll respond when I get home later (and I'm not on my company's computer network -- LOL).

[upcountryhorseman]

I operated a small consulting firm for many years. If
that is what you are looking at, I think the client
base is of critical importance. Question what is the
projected income from the recurring clients.

[Old Professer]

One of these most reliable measures of a company's worth is the ardor with which they approach investors; the more they court you the less likely they are to be solvent.