< PreviousA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 40 JULY | AUGUST 2021 the value examiner Size Matters Valuation of Small and Micro Businesses This column focuses on valuation issues unique to small or “micro” businesses. These businesses often have less financial and management information available, much of which may be deficient by GAAP or other standards. Therefore, valuators must do more qualitative review and apply greater professional judgment. By Gregory R. Caruso, JD, CPA, CVA /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// SMALL BUSINESS FOCUS T he valuation of small businesses 1 often presents challenges that do not arise when valuing middle- market and larger businesses. Two common mistakes valuators make are: 1. Understating company-specific risk, and 2. Understating long-term growth for early-stage and growth-stage companies. Assessing Risk Valuators who do not regularly value small businesses often understate the risks associated with them. Risk, for valuation purposes, is the perceived likelihood that a forecast cash flow will not be achieved. Small businesses are subject to risks that generally do not apply to large companies and, therefore, are not reflected in the public company data used to estimate the cost of capital under the build-up method. The most obvious of these risks are: • Geographic concentration 1 Defined as businesses with revenues under $10 million. • Product or service line concentration • Management concentration • Limited research and development • Limited credit Typically, when using income-based methods, these risks are captured by the company-specific risk premium (CSRP). Yet, on many valuations I review, the CSRP is understated. 2 Consider a mechanical contractor (HVAC) with $5 million in revenues and pretax cash flow of $800,000. 3 Table 1 shows a common range of discount rates that can be developed using several reliable data sources. 2 My firm has reviewed at least 25 valuations prepared for exit planning purposes and we have found that the capitalization rates tend to be too low. Price and value are not the same thing, but they should be reasonably related, especially when the purpose of the valuation is to prepare for a market sale. 3 For simplicity, we are using pretax cash flow in place of EBITDA in this example. Most small HVAC companies carry nominal long-term debt, so the variance is likely to be small. Valuing Small Businesses Using the Income Approach: Two Common MistakesA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES the value examiner JULY | AUGUST 2021 41 Method Discount Rate (rounded) “Standard” build-up before company-specific risk factor 12.60% 4 Duff & Phelps Risk Premium Report with regression equation 5 on 18.50% 6 “Implied” discount from DealStats median market data 7 19.20% 8 These measures are intended to be reasonably representative, although every estimate is unique. As you can see, use of the “standard” Ibbotson’s-based build- up method produces a much lower discount rate than the other methods and, therefore, a proportionately higher value (see Table 2). Note that I used a discount rate for this exercise in lieu of a capitalization rate, because deducting a growth factor would only make the variances between the build-up rates and the implied DealStats rate even larger. Presumably, the implied DealStats rate includes growth and really is a capitalization rate. Remember, with zero growth the capitalization rate and discount rate are the same. 4 “Ibbotsons” build-up before industry and company-specific risk factor calculated from Center for Research in Security Prices (CRSP) data (1926 to present) for cost of capital from the D&P Cost of Capital Navigator. Using a 12/31/2020 valuation date; no specified industry, as the closest “industry data” was large manufacturers of products, not installation contractors; 1.45 percent risk-free rate (20-year spot yield on T-bonds); 6.17 percent supply-side equity risk premium; and 4.99 percent size premium. Total = 12.61 percent before CSRP. 5 The regression equation is used to calculate size adjustments beyond data points generated from larger public companies. There is always risk in doing this as it is not “provable,” yet as shown above, it often produces a very reasonable starting point for small companies. 6 Calculated using $4 million equity market value; $2 million equity book value; $300,000 five-year average net income; $400,000 five-year average EBITDA; $5 million in net sales; and 25 employees, which produced an average levered cost of capital of 18.94 percent and a median of 18.44 percent. 7 Small businesses often have sufficient market comparables to support the market method and this type of analysis. For larger, middle-market businesses there rarely are sufficient market comparables to use the market method. 8 Calculated using post-1/1/2013 sale date; $3 million to $10 million in revenues; over $300,000 in EBITDA; NAICS Code 238220. Result: 22 comparables with median MVIC/EBITDA of 3.7. To tax-affect market multiple and create an after-tax capitalization rate, (1) divided 3.7 by .71 [1 - .29 (assumed 29 percent federal and state tax)] = 5.2, and (2) divided 100 by 5.2 = 19.18. Rounded to 19.2 percent discount rate. Table 1: Estimated Discount Rate Calculation Methods Valuators who do not regularly value small businesses often understate the risks associated with them. A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 42 JULY | AUGUST 2021 the value examiner Estimated Discount Rate Calculation MethodsUnadjusted Value 9 “Standard” build-up before company-specific risk factor $4,958,700 Duff & Phelps Risk Premium Report with regression equation on $3,377,300 “Implied” discount from DealStats median market data $3,254,200 Certainly, the low starting point provided by the standard build-up method can be adjusted in the CSRP, but in practice this adjustment tends to be insufficient. The problem is magnified with poorly performing companies that should have a high CSRP even when starting from one of the two higher discount rates. (How often do you see a 10 percent-plus CSRP?) To add a dose of reality to this example, consider that well-managed new-construction HVAC companies in this size range tend to be much riskier than service-oriented HVAC companies with more predictable cash flows. The new-construction firms often sell for only three times EBITDA because of the uncertainty inherent in cyclical, one-time, large-bid projects. Poorly run firms of this type may not be salable. This multiple (3x) equates to a 23.6 percent discount rate on after-tax cash flow, or an 11 percent CSRP for a small, well-performing new-construction-oriented firm. 10 Practice note. When using unadjusted build-up data to estimate the value of small businesses, recognize that company-specific adjustments may be quite large—often in the 6–14 percent range or even higher. Estimating Growth Rate for Early- and Growth-Stage Companies According to “common knowledge,” and basic math, using a 10 percent growth rate in the capitalization of earnings method (or when estimating the terminal value under the discounted cash flow method) will eventually produce a company cash flow larger than Walmart’s. This is true, but it may be misleading to focus on that point as we are estimating value, not cash flow, and the formulas include present value adjustments. The present value adjustments offset the cash flow growth and reduce value growth to manageable amounts. This high-growth situation occurs when valuing small companies in the later part of the startup phase and certainly through the growth stage of a typical company lifecycle. (See Figure 1.) For many small businesses, this lifecycle spans a 20- to 30-year period. 9 I took after-tax cash flow of $800,000, multiplied it by 1.1 to arrive at the next year’s cash flow of $880,000, multiplied that figure by 71 percent (to reflect federal and state taxes of 21 percent and 8 percent, respectively), and divided the result, $624,800, by the discount rates listed in Table 1. This demonstrates the problem of low discount rates and does not include the CSRP or any growth rate for estimating a capitalization rate. 10 Market multipliers for small businesses are pretax. To equate to pretax cap rate, 3x=33.33; to tax adjust, 33.33 x .71 tax rate = 23.6; to find CSRP (and industry premium if desired as that was not included) 23.6 – 12.6 “Standard” from Table 1 = 11 percent. Again, the variance would be even greater with the introduction of a deduction for long-term growth. Table 2: Range of ValuesA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES the value examiner JULY | AUGUST 2021 43 Figure 1: Typical Company Lifecycle over 20–25 Years Our focus in this article is the startup and growth period. Often these periods constitute five to ten years of high growth. Actual annual growth rates can be in the 100 percent range or more and often average 20–35 percent during this period. At some point many companies level off, often with revenues between $5 million and $15 million. For many owner-operated companies that revenue size range can be run efficiently with very low overhead. 11 For instance, a quickly growing mechanical contracting firm has grown the last three years as shown below. Management does not have a projection but believes the company will grow its bottom line by 20 percent per year on average for at least five years, then perhaps 5 percent per year for five years, and then level off to inflation (assumed to be 3 percent). The company has systems and management in place to facilitate at least the next two years’ growth and is very focused on maintaining control over operations, both financially and in terms of maintaining high service-delivery standards. Pre-Tax Cash Flow 325,000 400,000 800,000 CF% of Rev. 13.00%13.33%16.00% Pre-Tax Cash Flow Growth 23.08%100.00% 11 Many owners can directly run highly efficient small companies, but this comes at the expense of growth. Growth often requires significant expenditures on key people, reducing profits for several years. Many owners elect not to take that challenge on.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 44 JULY | AUGUST 2021 the value examiner For purposes of our discussion, we will assume a build-up discount rate of 25 percent. 12 Because we have no real projection or forecast, we elect to use a single period capitalization of earnings. The question at hand is what is a reasonable long-term growth rate? For value purposes a growth rate of 10 percent is supportable. The common knowledge that a 10 percent growth rate will quickly create a company larger than Exxon or Microsoft ignores the fact that in business valuation we discount cash flows to present values. Present valuing/discounting is achieved by using the following formula: PV = FV/(1+k) n , where PV = present value, FV = future value, k = discount rate, and n = number of periods. The Effect of Present-Valuing Cash Flows with Zero Growth Table 3 shows the growth in value over time of $100,000 when present-valued at commonly used discount or capitalization rates. (Remember a capitalization rate is a discount rate less long-term growth, therefore they are equally represented in Table 3.) So, for example, at a 25 percent capitalization rate, present-valuing $100,000 for 40 years would produce a present value of only $399,947. Put another way, $100,000 of cash flow starting in year zero with no growth equals $399,947 of total value after discounting at 25 percent over 40 years. $13 is being contributed to value in year 40, so there will be small additional contributions to value, but they are immaterial. Table 3: Value Growth over Time 12 If we take our previously calculated “implied” discount rate found in the first part of the article of 19 percent and then add a CSRP for a small early-stage growth company, 6 percent would appear reasonable and result in a 25 percent discount rate. Annual Cash Flow Amount Capitalization/Discount Rate Period 10.00% 15.00% 1 $90,909 $86,957 2 $82,645 $75,614 5 $62,092 $49,718 - 10 $38,554 $24,718 15 $23,939 $12,289 20 $14,864 $6,110 40 $2,209 $373 Tot@ 40 $977,905 $664,178 $100,000 20.00% 25.00% 30.00% 35.00% $83,333 $80,000 $76,923 $74,074 $69,444 $64,000 $59,172 $54,870 $40,188 $32,768 $26,� $22,301J $16,151 $10,737 $7,254 $4,974 $6,491 $3,518 $1,954 $1,1091 $2,608 $1,153 $526 $247 $68 $13 $3 s 1 I $499,660 $399,947 $333,324 $285,713 The reason for the box around the 15–30 percent discounts is that they represent a fairly common range of discounts for after-tax cash flows of small companies. Note how quickly contribution to total value drops each period as the discount rate gets higher. Remember, this also means that a projection that is optimistic in the early years and met “just a year” later than projected will cause the company to be materially overvalued at higher discount rates. Finally, note how little annual contribution remains at 40 years out at discount rates of 15 percent or more. The higher the discount rate, the lower the present value contribution to value as time goes on. Therefore, 10 percent growth applied to a 25 percent discount rate will not produce infinite cash flow. In fact, if the company is successful, it might understate growth. The calculation of value using the capitalization of earnings method is based on the Gordon Growth Theory. In order to adjust the discount rate for growth to estimate a capitalization rate, the growth rate is subtracted from the discount rate. The theory further states that cash flow is estimated with growth for the next period and then the capitalization rate is applied. Alternatively, we can adjust the discount rate for the additional year’s growth.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES the value examiner JULY | AUGUST 2021 45 Table 4: Increase in Value Due to Growth After-Tax 10% Growth RateCash FlowIndication of Value Discount rate 25.00%$624,800 $2,499,200 Less growth rate 10.00% Capitalization rate 15.00%$624,800 $4,165,333 Increase in value due to growth $1,666,133 Table 4 shows the increase in value on a year 0 cash flow of $800,000. After-tax cash flow is multiplied by 1.1 to arrive at the next year’s cash flow of $880,000, which is multiplied by 0.71 to yield after-tax cash flow of $624,800, which is then divided by the capitalization rate. 13 Note that the value increase due to a 10 percent growth rate with a 25 percent discount rate is $1,666,100 (rounded), which is reasonable under the assumptions above. Practice note: Without discounting, a 10 percent growth rate on an $800,000 start value over 40 years will produce a pretax cash flow (not value) of over $35 million in year 40. Yet, after present-valuing the cash flow, the growth in value is a manageable amount. 14 Therefore, within reason when valuing small companies in the growth phase using the capitalization of earnings method (or estimating terminal value if the projection period is very short), long-term growth rates above 6 percent can be justified and reasonable. Conclusion This article reviews two common mistakes when valuing small businesses, which may offset each other but usually do not. Valuators using a “standard” build-up approach to develop a discount or capitalization rate may be substantially underestimating company-specific risk and overstating value. On the other hand, young growth companies, for which high growth rates are reasonable over the next five or so years, may have higher long-term growth rates than the typical “top” growth rate of 6 percent. 15 As always when valuing small businesses, it is critical to step back at each step of the valuation process and be sure you can affirmatively answer the question, “Does this make sense?” VE Gregory R. Caruso, JD, CPA, CVA, is the author of The Art of Business Valuation: Accurately Valuing a Small Business, which starts with the question, “Does this make sense?,” to get to the heart of the process of developing, reviewing, and using credible business valuations (www.theartofbusinessvaluation.com). Mr. Caruso’s firm, Harvest Business, LLC, has been involved in business valuation and business brokerage within construction, engineering, and other fields for the past 20 years. He is the former editor in chief of NACVA’s Around the Valuation World and a member of NACVA’s Ethics Oversight Board. Email: gcaruso@harvestbusiness.com. 13 See n. 9. 14 $800,000 growing at 10 percent per year for 60 years with no present valuing results in a total cash flow of $333,900,000 rounded. Another way of looking at the value increase is to use a 60-year discounted cash flow model at a 15 percent present value of the cash flow over 60 years in which case the value growth is $2,047,200. There is an immaterial remaining value increase after 60 years. 15 Of course if you have an unrealistically low discount rate and then apply a high long-term growth rate you are likely to create a mess.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 46 JULY | AUGUST 2021 the value examiner I hope you enjoyed the May/June interview with Malcolm McLelland. Our interview series continues, with this issue featuring Andrew Park. Snapshot: My credentials: CPA, CFF, CGMA, CFE, CVA I’m located in: New York City and New Jersey On my own since: January 2009 Name of my firm: Andrew M. Park, CPA, PC My practice sweet spot is: Economic damage analysis, financial embezzlement and misappropriation, divorce litigation, white-collar criminal defense, and business appraisals Typical size company/case I deal with: The company size varies, but generally ranges from $2 million to $25 million in gross revenue. Rod: So, the BVFLS profession isn’t exactly a calling. Tell us about your background and how you got to where you are today. Andrew: I started my career doing traditional accounting work in small and mid-sized public accounting firms. Forensics and valuation were not as popular in those firms back then as they are now. I found myself placed on the most challenging engagements. Most of the managers and staff accountants did not want to be on these jobs. At the time, it was a compliment since I enjoyed the challenges, opportunities, learning, and obstacles. But over the years, the consistent traveling, late nights, weekends, and holidays started to take their toll. In hindsight, however, this was a blessing in disguise. The challenging jobs developed my curiosity and professional skepticism, and I branched out of traditional accounting. During this time, I also considered going to law school, but I realized my strength is in numbers, analytical skills, and the ability to teach an audience. This started my path to the forensic accounting and business valuation profession. Eventually, I started my practice, which focuses on forensic accounting, economic damages, business valuation, financial misappropriation, embezzlement, divorce litigation, and white- collar criminal matters. I’ve been fortunate to have many varied opportunities along the way. Rod: What was your first year like, and what would have made it better? Andrew: I started my practice with no revenue, no clients, and no business. I shared a small office with a financial advisor in a sketchy neighborhood. Since I had no clients, the phone never rang. I would wonder if my phone was working so I occasionally called myself just to make sure it was! Since I had so much time on my hands, I decided to focus on business development. I got started by attending traditional professional networking events and other special events, such as fundraising events with golf tournaments and local community nonprofit organizations. In that first year, I only had one small engagement. It was a referral from a friend who knew someone who needed some forensic accounting. Eventually, my practice developed in its second and third years. Recently, I’ve noticed more INTERVIEW: Andrew Park Andrew Park PRACTICE MANAGEMENT Practicing Solo “Practicing Solo” features interviews with our industry’s new and seasoned sole practitioners. If you are itching to join the solo ranks, or striving to be more efficient and effective in your established one-person firm, this column offers practical advice, steeped in experience from the trenches, that can move you forward. By Rod P. Burkert, CPA, CVA /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// ///////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES the value examiner JULY | AUGUST 2021 47 sole practitioners start their practices with several engagements and clients/ attorneys lined up prior to branching off on their own rather than developing them from scratch. Rod: Did you have a formal (or even semi-formal) business plan? Andrew: Yes, I had a semi-formal business plan. However, since I had never run a business by myself, there were many unexpected circumstances that distracted me from my goal. For example, as my practice developed, the office location, employees, resources, and overall needs for the practice changed. Also, the fast pace of technology changes required me to adapt on that front as well. Every year is different. You cannot go into the year assuming it will be similar to last year. Therefore, it’s a good idea to have a formal plan; however, be ready to adjust and adapt to unexpected changes. Rod: How did you first attract clients, and how did that strategy evolve over time? Andrew: I started to build the practice by increasing my exposure. For example, I attended networking events and became active with my local professional organizations, such as my state CPA society, ACFE, and NACVA. I also started to speak at various seminars and CPE sessions. In the beginning, this was a challenge because I’ve always been an introvert. Public speaking at seminars and starting conversations with strangers in public settings were unfamiliar territories and a skill set that was not developed during my time at the public accounting firms I previously worked for. I’ve had the opportunity to meet many people from various industries. Fortunately, opportunities started to present themselves in different shapes and sizes. Some opportunities involve meeting people who you can connect and become friends with as well as business colleagues. Other opportunities involve being in a position to help other professionals. Therefore, not all opportunities start with an engagement letter and end with a check. In my experience, my practice evolved more from the people I’ve met as well as the engagements I’ve completed. Rod: Do you practice in a specialized niche today? Andrew: My practice is specialized to a certain degree. I focus on economic damages, financial embezzlement and misappropriation, divorce litigation, business valuations, and white-collar criminal defense matters for small businesses and individuals. And although I work on cases in states like California, Florida, Illinois, and Texas, most of my engagements tend to be in New York, New Jersey, Connecticut, and Pennsylvania, since my practice is centered in New York City and New Jersey. Rod: What has been your best marketing tactic? Andrew: When I started my practice, my goal was long term with less emphasis on making money or “growing my business” (although that certainly is important to pay the bills and other survival obligations). Rather, it was to develop a high level Some opportunities involve meeting people who you can connect and become friends with as well as business colleagues. Other opportunities involve being in a position to help other professionals.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 48 JULY | AUGUST 2021 the value examiner of integrity and professionalism for the profession and within the community. So, I’m constantly working on how I conduct my work and my attitude toward clients, colleagues, and employees. As professionals, we are known by our reputation. Therefore, a good, strong reputation with a high level of trust and integrity goes a long way—beyond the professional world. Rod: How do you price your work? Andrew: My fees are generally set according to an hourly rate. If the engagement is non-litigation and more or less “friendly” and I’m able to estimate the amount of time to complete the job, then I provide an estimated fixed fee. Rod: Where do you get your “runner’s high” from: (1) getting the work (e.g., practice development), (2) doing the work (e.g., an intellectually challenging analysis), or (3) delivering the work (e.g., reviewing a report with a client)? Andrew: As a sole practitioner, you tend to be involved in all three aspects equally. Therefore, all three numbers are equally important. My “runner’s high” depends on the engagement since every case and matter is different. Therefore, my answer to this question will depend on the engagement because we tend to be involved in the cases from the beginning to end. Rod: How do you differentiate yourself from larger firms? Andrew: Besides the professional service fees, I have not needed to differentiate myself from the larger firms. The reason my firm is more cost-effective than larger firms is that my overhead is lower, therefore, I have more flexibility with my fees. Furthermore, I’ve found that certain clients prefer to work directly with the owner while others are indifferent. In my firm, I tend to be involved in either a portion or the entire matter. However, this has not been a concern since most of the clients who typically contact my firm have certain expectations of a small firm. I’m certain when clients contact a larger firm, there are certain expectations of a large firm. Rod: Do you work from a home office or an “office” office? Why? Andrew: I work at an “office” office because the setup and environment makes me more productive. My associates are at the office so it’s more efficient and dynamic when we are centralized and physically working together. Rod: What is your current mobile device? Andrew: iPhone 8. Rod: Describe your current computer/workstation setup. Andrew : My workstation setup is a desktop computer with three monitors, speakers, wireless keyboard, mouse, calculator, telephone, and an iPad that rarely leaves the office. I also have a few signed baseballs and other sports memorabilia, such as plaques, by the opposite end of my office. Occasionally, I’ll also have a picture of my children next to my calculator, depending on what we did over the weekend. As professionals, we are known by our reputation. Therefore, a good, strong reputation with a high level of trust and integrity goes a long way—beyond the professional world. I Want to Sell My Business I Need Estate Planning I'm Getting a Divorce Certified Valuation Analyst I'm Missing Out My Partnership is Dissolving Co-Sponsored by the National Association of Certified Valuators and Analysts® (NACVA®) Visit www.theCTI.com/BVTC or Call (800) 677-2009 Early registration discounts available. Dates and locations subject to change. 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