2005
By Gary Pittsford, CFP®
President and CEO, Castle Wealth Advisors, LLC

Putting a value on a closely held family business is not an easy process. Every business is different and has unique aspects that could increase or decrease its value. In the hardware, lumber, lawn and garden, and home center industry, there are many factors that affect your business value.

A fair price for your company is the “negotiated price a willing seller and buyer agree on, after all important facts about the business are fully disclosed.”

Below are seven commonlyasked questions that I hear often, with answers about valuations and how those reports can impact your business.

Question: What is a buyer looking for?

Answer: It doesn’t matter if the buyer is a stranger, one of your children or key employees who have been with you for a long time. They all need to know the cash flow generated by this business. For example, if two stores have gross income of $1 million each and Store One has a profit of $10,000 and Store Two has a profit of $50,000, is Store Two more valuable?

When you look at Store Two, are all key personnel going to remain? Did the owner and most knowledgeable employee just become disabled and unable to return to work? Has the rent been low in the past and the new lease agreement is about to be renewed at a much higher rate? With Store One, was the owner taking a very high salary that provided the company with a low taxable income? The owner of Store One has a lot of bank debt, and as a result the store was paying $30,000 a year in interest? Are the gross margins on products sold in Store One too low?

Just because Store Two had more profit on their tax return last year than Store One doesn’t necessarily mean that Store Two is more valuable.

Question: What are the different types of appraisals commonly used for this industry?

Answer: For smaller retail operations with less than $800,000 to $1 million gross income, the valuation most commonly used is a “net asset approach.” This method looks at the assets owned by the business, such as inventory, furniture and fixtures, cash, accounts receivable and equipment. These assets are examined and adjusted if necessary. For example, perhaps the inventory should be decreased 10% because the owner has retained obsolete or slow-moving items.

Perhaps accounts receivable should be adjusted down because there is a large dollar amount over 120 days. Usually, this method includes some goodwill value to recognize that the store is probably well-known in its area and has many repeat customers. For smaller stores, it is hard to provide a predictable long-term cash flow. This is why this method gives the buyer a logical value he can count on when he takes over. The buyer looks at these values and will try to predict gross income and potential profit.

A second method that could be used is the “market comparison approach.” This method is commonly used in valuing publicly traded companies because all financial and operation information is available. The buyer can learn everything about the company during their due diligence process. The important details of a sale are available to the public.

However, for privately held businesses, details are not disclosed to the public because the seller does not want anyone to know their business affairs, and the buyer doesn’t want anyone to know what they paid for the business. Unfortunately this method, which could be very useful, is not available to closely held private businesses in the retail hardware industry.

A third method is called “capitalization of earnings.” This method takes a hard look at cash flow generated by the business. It looks at the gross margins for the store and each department. It examines expenses such as payroll, rent, owner’s salary, bank interest payments and any other expenses pertinent to this company. All usable cash flow is pulled out of the income and expense statements and becomes the total cash flow with which the buyer can work. For example, a retail store may have gross income of $3 million and a yearend net profit of $100,000. However, the owner has the luxury of taking a high salary. Therefore, a potential buyer could add back part of the salary as usable cash flow.

Perhaps this store paid $50,000 in interest on bank loans or paid higher-than-normal rent because the owner owned the building personally. The appraiser would total all profit, excess expenses and any other usable cash flow to arrive at the cash flow available for a potential buyer. In this situation, the seller has a company that historically provides a certain cash flow when these numbers are added together, and the buyer will purchase the company based on this excess cash flow.

In most valuation text books, this total cash flow is called “EBITDA” (Earnings Before Interest, Taxes, Depreciation and Amortization). The buyer is counting on the EBITDA as it is all he has to work with. With cash flow coming from the business, the buyer has to provide a salary for himself, pay all employees and employee benefits, pay vendors, bank loans and meet all financial obligations.

Question: In addition to profit and cash flow, what else is important in valuing a business?

Answer:Well trained, season employees are very important in the success of any company. If you are selling a business, can you provide the buyer with several long term employees who know their jobs well and will be instrumental in helping the new buyer make a profit his first year? Well-trained employees who remain with the business prop up the value.

How much competition is there? The business has been in the same location for twenty years. Is it still the best place to be or should the buyer move it to a different neighborhood? Does it have the right product mix for the area where it is located? Just because the paint department had great sales fifteen years ago, this is no reason to keep it today. If competition for paint has increased, perhaps this square footage should be converted to a rental area, or perhaps a lawn and garden department.

Buyers are looking for a retail store with the right departments and gross margins for the area of the city where it is located. They are looking for well-trained employees whom they can count on. They’re looking for low expense and high profit. Most buyers aren’t lucky enough to get everything they want, but these are some of the important questions they want answered before writing a big check.

Question: What are these valuations used for?

Answer: Valuations most often are used when a stockholder dies and a value must be placed on the stock for probate. Unfortunately, a second reason is when there is a divorce. As part of the divorce process, both sides need to know the marketable value of the closely held family business.

Valuations are used when a stockholder becomes disabled or is terminated from employment and his stock needs to be repurchased by the company.

When the owner is ready to gift stock to one or more children, a valuation is needed to establish a price for each share of stock. Not only is the company valued, but also discounts are applied to the stock if the recipient does not have voting control. These discounts are very important to the parents and helpful for the overall gifting process with the children. Also, a copy of the valuation report is usually included with the gift tax return prepared by the accountant.

Many people are not aware of the different values placed on company stock based on the situation. If the most knowledgeable person just died, the value of the business would drop. If the husband and wife work together seven days a week in running the business and one of them leaves, the value drops. If a hard working brother or uncle wants to retire, this will affect stock value. If the father wants to retire and sell the business to one or two of his children who have been working in the business for many years, perhaps the stock value would not be impacted as much.

Question: What type of information is needed for a typical valuation?

Answer: The person doing the valuation needs to start with the last five years’ financial statements and tax returns. If the company doesn’t have this much, perhaps there would be at least three years. It is in the best interest of the store owner to provide information about deductible expenses in the past which the new owner would not have.

For example, if the seller has season tickets for a football team where he takes his best customers, the buyer may not want to do this.

Therefore, the cost of the tickets could be added back to the cash flow calculation. Any other expenses the seller currently has and the buyer does not wish to continue can also be added back to cash flow.

During the valuation process, the person collecting the data will need to discuss employees and their stability, location of the store and any new competitors, the condition of the store, parking lot and surrounding area and all other factors affecting sales potential of this store. The appraiser will ask many questions about the operation of the store, employees, family members who work at the store and anything else that seems pertinent to the valuation process.

Question: Can this valuation process and the report generated help the seller in marketing the store?

Answer: A store valuation report would be slightly different than a marketing brochure, but the information needed to market the company would typically come from a valuation report.

A typical buyer wants facts about this store. Facts would include gross margins, profitability, inventory, accounts receivable and other information normally found in a valuation report. Sometimes the valuation report in its entirety would be given to a potential buyer and sometimes a marketing brochure would be put together that would contain some financial information on the company. A typical valuation report looks back five years to arrive at financial conclusions. On the other hand, a marketing brochure looks back one or two years and forward one or two years with some financial projections. Also, the brochure the seller wants to give to a potential buyer would emphasize, for example, the low rent, qualified employees and other important points for the company.

Question: What rates of return are buyers looking for?

Answer: The rate of return that should be received from investing in an illiquid, closely- held corporation is always the $64,000 question. The actual rate of return that goes into a valuation report is a build-up of several numbers.

If treasury bonds are paying 4% to 5%, the buyer would want a higher return than that. If the assumed rate of return for buying stocks on the New York Stock Exchange is 8%, the buyer would want more than that. Venture capital companies often invest in privately held companies with a negotiated rate of return of 30% to 35%.

Perhaps that return would be too high for a typical company in your industry. Therefore, the rate of return that most buyers are looking for is somewhere in the middle so they have some equitable return on their investment capital in return for taking the risk of owning a closely held nonpublic corporation.

If the buyer is a member of your family, perhaps they would be willing to take over control of this closely held business and receive a lower return because they plan to keep the company in the family. If the buyer is not a family member, they will want a higher return for their investment.

If the valuation is based on a net asset approach, the buyer wants to be sure the values for the company accurately reflect the assets in the company. If the buyer feels he is paying a fair price for the net worth of the company and additional goodwill, the store will probably continue to generate the amount of cash flow that it has in the past, or perhaps better. The buyer needs to be sure that he understands what the cash flow has been over the last several years. Also, are the conditions with the company the same as in the past so the cash flow will continue to be the same?

If the valuation is prepared using the capitalization rate analysis method, the cash flow the company generates has already been calculated and becomes part of the report. By looking at the EBITDA, the buyer can easily see how much cash flow there is to work with. Capitalization rates vary among companies, and no two are alike. In the past few years, most capitalization rates for privately held family businesses have generally been between 14% and 29%.

Obviously, if there is a problem with company management or the location, the capitalization rate would be higher. If the current managers plan to stay and all else about the company looks excellent, the capitalization rate would be lower. Some people like to use a “rule of thumb” of 20%, but this generalized rate is not appropriate for most companies because there is almost always some problem with management, location, level of expenses, rent or gross margins. When the valuation of a company is put together, there are so many aspects to be considered, you can never use just one general rate of return.

The rate of return that is used in a valuation is based on historical financial information and cannot predict the profit level of a store over the next three to five years. The success a new buyer would have over the next three to five years with a store they just purchased depends on their management skills, ability to maintain gross margins, ability to keep and train excellent employees, plus many other factors.

Because the buyer is usually an unknown quantity, there is no way to predict how successful that individual will be. Therefore, if someone buys a company which has, for the last several years, averaged a return on stockholder equity equal to or better than the national averages, the buyer can only hope that his/her management ability is as good or better than the seller. The return on stockholder equity (pre-tax) according to the latest report from the National Retail Hardware Association varies from 8.6% for a typical hardware store to 22.6% for high-profit hardware store.

When you look at closely held corporations in this country, it is one area where someone can invest and receive a return on that investment that is much higher than the average stock market, real estate or owning many other types of investments. However, with that potentially higher rate of return on invested capital come the added risks of an illiquid investment, management of all aspects of the company and competition. If the buyer can successfully handle the negative aspects, the potential rate of return should be very rewarding.

Summary

Paying someone to review the financial performance of your company and put a value on it is a necessary process for many owners of closely held businesses for the reasons discussed above. If you are the president of a publicly held business, your performance and that of the company’s is valued every day on the stock exchange.

But the valuation process for owners of closely held family businesses is not done every day, but it does become necessary for selling, probate, gifting, divorce, retirement and other reasons. Getting a valuation for your business may feel as if you are getting a grade on your performance as manager of the company. And this is true to an extent. But valuations are sometimes needed when family members are negotiating the price of stock and are required if the family is dealing with a probate court, divorce court or civil court.

Many times we have seen a detailed valuation report provide excellent information to the owners of a business that immediately helps them improve profitability of the company. More than once, we have reviewed a company that has lost money every year the last three to four years. After reviewing the information in the valuation report, the owners were able to immediately turn the company around and realize a profit the next year. Sometimes, a fresh pair of eyes can give the owner a new perspective on the company performance.

I hope this article helps you understand more of the detail that goes into the valuation process of a closely held family business.

Gary Pittsford, CFP®, is President and CEO of Castle Wealth Advisors, LLC. Castle specializes in helping families and closely held business owners with valuations, succession planning, estate and income tax analysis and retirement income security. Castle’s senior partners work with clients throughout the country in making logical decisions that help them fulfill their personal and business financial goals. For more information visit www.Castle3.com, call 1-888-849-9559 or e-mail Gary directly at .