Speaker 1:
As bank that focuses on business, we work with business leaders all day, every day. We have a front row seat to what's working and what has potential. The First Business Bank podcast is dedicated to sharing insights to help you work better, smarter, and faster to achieve your goals. Let's get into the show.
Mark Meloy:
Hello, I'm Mark Meloy, CEO of First Business Bank. I'd like to welcome you to another episode of The First Business Bank podcast. Today's topic is determining the value of your business, whether you're a seller, a buyer, a nosy neighbor, or sometimes even the government. Everyone wants to know the answer to what's your business worth. Today's conversation promises to be an interesting one. I'm joined by two experienced professionals in the fields of valuation and finance. So before we get things started, they'll each introduce themselves. Jane, we'll start with you.
Jane Tereba:
Hi everyone. My name is Jane Tereba and I'm a shareholder with Capital Valuation Group. We are a firm that's been in business since 1974, focusing on two things. One is valuing the equity in a privately held business and the other is determining economic damages to a business in litigation settings. Before I started with Capital Valuation Group, I've been here for about eight years, I was in public accounting for about 15 years before that.
Mark Meloy:
Thanks, Jane. Josh.
Josh Hoesch:
Hello everyone. My name's Josh Hoesch. I've been in commercial banking for 17 years. Currently, I work for First Business Bank here in Madison, Wisconsin.
Mark Meloy:
All right. Jane, I'm going to start this topic off with you first, and Josh, please join in with the first question. Jane, why would someone want to determine the value of their business?
Jane Tereba:
Well, certainly it's to answer the questions of the nosy neighbors, but in reality, people ask for business valuations for a variety of reasons. Most often it's related to a transaction, but if you think about from a business owner's perspective, business valuation really can be a helpful tool in planning. For most business owners, a significant portion of their personal wealth, if not all of their personal wealth, is invested in their closely held business, but most business owners have no idea what the value of that investment is. So a good business valuation can help the business owner effectively plan for the future and we can also help provide guidance for increasing the company's value.
Jane Tereba:
So a couple other reasons other than transactions that people will get valuations would be for retirement planning or working towards an exit strategy. Maybe just knowing what you're doing every day is positively impacting the business from a valuation perspective, so tracking that increase in value over time. And we also have clients that have incentive plans that are tied to business valuation to show that, as you know, managements positive impact on company value. And then, like you mentioned earlier, Mark, of course we do valuation work for IRS purposes, whether it's for the gift tax purposes, estate planning, other more regulatory types of reasons, but generally speaking it's for good planning and making sure that you understand that value when you're doing your personal wealth management.
Mark Meloy:
Thanks, Jane. Josh.
Josh Hoesch:
From a banking perspective we can provide a range of typical industry info that they can use to value the company. But yeah, we have conversations every day about what their plans are. Succession planning is important to us on, "Hey, who's going to run your business some days?" So when we're lending them money, we'd like to know who the managers are. I mean, I know at First Business Bank, one of the things that we focus a lot on is the character and quality of the management team. And so having a good understanding of succession plan, how are they going to hand it off to somebody else, but also harvest what they've worked so hard for and how the piece of that is determining the value. And so we can only do so much and so we refer them out to experts, like Jane's firm, to get an expert opinion on what their company may be valued at.
Mark Meloy:
Jane, can you explain a few of the most common approaches to determining a business's value?
Jane Tereba:
Sure. There are actually three approaches. There are the income approach, the asset approach, and the market approach, and each one of those should be contemplated in a business valuation. We most often rely on the income approach as we feel that it gives the best reflection of the business's value. So there are actually, and underneath each one of those approaches, there are different techniques. Under that income approach, in general, what you're talking about is a valuation that's based on some income metric of the business itself. So there are two methodologies. One is called the discounted cash flow method, which relies and creates projections, financial projections, for the company that serve as the foundation of the business's value. The other common methodology under the income approach is called the historical capitalization of earnings, or capitalization of historical earnings, sometimes it's referred to both ways, and that really does rely on the historical income statement not really making forward looking projections.
Jane Tereba:
Though it is an assumption that the company will continue to operate as it has in the past. The reason that we like looking at the discounted cash flow method is because we all know privately held businesses are very dynamic. They're never really the same every day. There's going to be a point in time where maybe your plant hits capacity if you're a manufacturer or you're part of a franchise that requires some kind of a rebranding every few years as your franchise agreement re-ups. So there are things that don't always happen the same. So that's why we prefer that discounted cash flow method, because it takes into account more the business's actual business plan going forward. But again, really the income approach focuses on the business's income. The asset approach is really a floor to value. If you think about a balance sheet, all of the assets are restated to their current market value, so if there's equipment or property that's held in the business, those would be restated to the current market values of those assets. You subtract the debt, and that's essentially the value of the company.
Jane Tereba:
The drawback is that you can't really quantify good will, or any blue sky, or any intangible value when you're doing an asset approach, so that's why it's really considered kind of a floor of value. And then the last approach is the market approach, which is really a substitution. If you think about appraising your home, most home appraisers will use a market approach where they'll go out and look for comparable homes, and then apply those metrics to the home that they're appraising. Similar in a business, you go out and look for transaction multiples, or transaction details, that you can then apply to the company that you are valuing as a substitution principle. And that one's a little bit tougher in a privately held company world just because the transaction data isn't as readily available.
Jane Tereba:
And also there are things that can impact value transaction prices I should say. Motivations, buyers and sellers, terms of the deal, other things that can impact that price that aren't really value driven, they're more transaction driven. So it's something that we always consider, but don't often rely on in our final conclusion, but those are the three different methodologies that should be considered in every valuation.
Mark Meloy:
So I have two follow up questions on that. Does it matter, or does it vary, by industry or the size of the business?
Jane Tereba:
So the impact those three valuation methodologies, you would do the same process regardless of the industry. The place where there are differences would be if you have like a real estate holding company, or an operating company, that's very asset intensive. That's where we might end up using the asset approach more than those income approaches, or market approaches, just because the assets are so intensive and the operations aren't necessarily going to create a lot of good will or intangible value. So that's really one of the biggest differentiators that we consider when we're bringing in a new engagement and what methodology to apply is really are they asset intensive? A real estate holding company will tend to use more the asset approach. Otherwise, really any operating entity, regardless of the industry, that income approach, the discounted cash flow methodology, is going to hold regardless of what industry you're looking at.
Mark Meloy:
So the next question I have is one that comes into play a lot with privately held companies, or it seems to come in to play a lot, sometimes makes local news and what's going on in the business world, and that has to do with the difference when considering ownership percentages. What needs to be thought about there?
Jane Tereba:
Yeah, there's definitely a real difference between valuing a controlling interest of a company and a minority interest of a company. A controlling owner, if you have 51% of the equity or more, you have really control over everything. You have control over the cash flow. What does that mean? That means that you can set owner compensation however you want to, whether it's going to be above market compensation or below tax planning, it's under your discretion. The owner compensation is your discretion. The other thing you have control over is the capital structure. That means, what is the capital structure? A capital structure is how is the business funded? It's funded with private equity, your own contributions is equity into the business, and debt. And then a controlling owner can decide how much debt and how much equity to have in the business, and that capital structure really matters in valuation.
Jane Tereba:
And the other thing you can do when you have control is other things is you can't quantify in those two places. You can hire and fire people. You can appoint boards of directors. You can declare dividends. You can buy a business. You can diversify. So there are all those other prerogatives of control that exist that you can't even quantify in either cash or the capital structure. All of those things said mean that the controlling owners value is going to be higher than a minority's, generally higher than a minority value. So it's not correct to say if I know that my whole business is worth $100,000, and I own certain 5% of it, that my ownership interest is 5% of $100,000. My 5% is going to be subject to a lot of different issues.
Jane Tereba:
I can't control the cash flows. I can't control the capital structure. I'm at the mercy of the controlling owner. And I also have this thing called marketability. I had to be able to sell my 5% interest. And generally in the privately held companies that we work with, there are all sorts of transfer restrictions on a minority shareholder. The company has a first right of refusal or where they have to match any terms that I might get from an outside party. All of those kinds of things make my 5% interest much less marketable than 100%. So you have very real differences between the controlling ownership value and the minority ownership value.
Mark Meloy:
Josh, you touched on this a little bit in your introduction, but what's most important for business owners to keep in mind before they start preparing for a valuation of their company?
Josh Hoesch:
Yeah, there's a few things. I just talked with a client today about, "Hey, what are you thinking about your succession plan?" He's in his mid to late 60's, his father just passed away, so he is thinking about some of these things, and he told me, "Hey, I'll think about that in a couple years when I want to sell." And I thought, it's not an uncommon thing for a business owner to say because they're in the business. He's having a hard time finding employees, so he's in the day-to-day right now, and he doesn't really want to... He thinks about it, but he doesn't want to deal with it. And I think, going back to what Jane said earlier, you need a plan for things. And so you want to start earlier than later. We can all help.
Josh Hoesch:
Your business partners can help you set things up so that you can get the highest price for your business if your end goal is to sell it at some point. So I think planning is number one. Manage your expectations, get to know the market, understand what people are valuing. Who's in the market to purchase a company like yours that's in that industry and then be open-minded about the process. Get your financial statements in order. Maybe you spend a little more to have an accounting firm provide reviewed, or audited, financial statements and so when you go to Jane, you go to Capital Valuations, or another valuation company, you have things in order, and they're ready to go to really help you start planning and determining valuation on your company.
Mark Meloy:
So I think we're all in agreement that you can start too late preparing for a sale, but can you start too early? Josh, I'll have you go with that one first.
Josh Hoesch:
Yeah. The short answer's no. I think you should always be planning for an event, right? And it might be something unexpected or it might be something planned. And so you always want to [inaudible 00:13:09] your company in a way that you're going to get the most value for your company at any given time. So I think the short answer is no.
Jane Tereba:
And I would just add on that the more time you have to prepare the better. I mean, when you enter into a transaction, regardless of what the value of the business is, if you think about selling your home, for example, especially in this market, you think about selling your home, you find out what the appraised value you is, and then depending on how fast you want to move or how fast the buyer wants to move in, and that can all impact the actual transaction price. Well, it's really not that different than selling your business. The longer you have to prepare, the longer your runway is, if you know what the value of the business is today you can know, is that what I was expecting? We've met with a client, he was fairly young, and they were doing some family planning. It was a very asset intensive business. He had gotten some advice from his accountant that the value of the business was like three times revenue or one times revenue.
Jane Tereba:
That was his advice. So he came into our office, after we had done all the valuation work, and we said, "Okay, well, what do you think the business is worth?" He said, "$18 million." Our conclusion was three and a half. So because he had bad advice, I mean, now he had to adjust his whole outlook on what his business was worth to three and a half million rather than 18. Well, now he's got three and a half.
Jane Tereba:
Now, he's got something he can work with and now he's got a long runway, because he was a fairly young owner, to figure out what is going to be my exit? How am I going to increase the value if it's really going to be 18 million? Is that even possible to get to? And if so, how? So the longer you give yourself time to adjust to that answer, the better. And you might run into things where something unexpected happens. You've got a major repair, or a significant opportunity that comes up, a great hire. All those things can be taken into account, but again, the more time you give yourself the better.
Mark Meloy:
Yeah, those are two great responses. The one thing I always tell business owners, especially when they're getting started is don't treat this like it's a piggy bank. Don't treat it like it's your money. Treat it like it's a business. From what you put into it, and what you take out of it, how you operate it, the financial reporting, so on and so forth. I think it's very simplistic, but it's very real in terms of how to ultimately maximize the value of your business.
Josh Hoesch:
Mark, and we've always heard, and I always hear that clients are always tax planning, but they never talk about value planning, right? So your decisions that you're making all the time, buying a piece of equipment, buying that piece of real estate, trying to win that next contract, how is that adding value to the business versus always trying to manage your bottom line so you don't have to pay tax?
Jane Tereba:
And actually that's a great point, Josh. How to prepare to a valuation. I think that's where we started this. One of the things you should would do when you're starting to look at valuation is stop the tax planning, especially if you're trying to really manage that bottom line, because if you're going to go and try to sell the business, and convince a buyer that the profitability really should be a lot higher, but for your tax planning, the more you can stop that in advance, the better your result will be as well.
Mark Meloy:
You reminded me of... This is a story from my early banking career. And so it was a successful multi bar owner business person who came into the bank that I was working at, not in Madison. He wanted to borrow $100,000 to rent some new space and do what was going to be a third bar in the downtown that we lived in. And he brought me his financials, and of course, he never made any money. He always lost money. It's a bar, right? And it's a cash business and so on and so forth. And I had to say no, because there was no way to prove his ability to pay it back. And his face was getting redder. He was more angry with me. And so we sat there in silence for a little bit and I said, "So what's next?"
Mark Meloy:
And he goes, "Well, what's next is I have to go in my safety deposit box and take the $100,000 of cash out of it and pay for it myself." And it's one of those things where, what's he doing? Is he tax planning or is he building value? And I think that's one of my favorite stories from my banking history. So Jane, we got to keep moving on here. So I'm going to start this one with you. What are some qualities business owners should look for when selecting partners for a valuation process?
Jane Tereba:
Yeah, I would say you really want to look for a partner who's going to take time to get to know your business. Any appraiser's going to ask for a laundry list of documents, financial statements, agreements, operating agreements, debt agreements, all sorts of things. We're going to ask for the kitchen sink. But you want to find somebody who's going to take that and then work with you to understand it and not just work behind the scenes, not request a meeting with you, and just come up with a value. The feedback that we get from our clients is that it's not an easy process. We want to go through this with you and we want to go through your plans. What are the challenges? What are the opportunities? What are the risks? So that we can really understand because business valuation is about two things.
Jane Tereba:
It's about cash flow. If I'm a buyer, I'm going to come in and buy a business, and that's fair market value. The definition is a transaction between a hypothetical buyer and seller. So if I'm a buyer of this business, how am I going to get my return? So I'm interested in knowing what the future cash flow is. What is the profitability to me as the new buyer? That's one piece. What is the risk to me as the new buyer? If you don't have somebody that's going to take the time to get to know your business, and understand the financial trends of your business, and not ask those kinds of questions, and really take the time that it takes to get the story, you're not going to get a quality conclusion. If somebody just wants your financial statements, and they're going to just plug it in, and plug and chug, and give you an answer, that doesn't tell you how your business is unique. That doesn't value your value proposition.
Jane Tereba:
They didn't take the time to understand you, that your risks, and everything else. They just said, "Well, you're just a cog, just like any other cog." But that's not true of any privately held business. I think all of us at our privately held businesses believe that there is something unique about us, that we bring something different to the table that should be considered in the valuation. There are things like what's your management structure like? How diversified is your customer base? How's your relationship with your workforce? What is your debt tolerance? How much debt would you be able to take on? And things like that. How reliant is the business on certain customers? How reliant is it on the management team? All those questions should be asked and discussed before a valuation can be done.
Jane Tereba:
And the other thing is you want to be able to find somebody that you can understand somebody who can clearly explain the process to you, explain all the different procedures, all the steps, so that at the end, you understood what you just went through. And some of it's technical. I mean, there's no doubt that when we start talking discount rates, we love to talk about discount rates, but it gets a little financial and little finance techy 101, but we want you to understand what it means to have this risk and have the different adjustments that we might make to a capital structure. But at the end, I want you to understand what that meant. And then the other thing that's important is as you, especially when you're valuing those minority interests, somebody who can take your operating agreements and really understand the nuances of how those operating agreements do impact value, and the transfer restrictions, and the distribution requirements, or lack thereof, and how those things, just as two examples might impact your company's value.
Jane Tereba:
So again, just somebody that's going to take the time to really dig in, ask the questions, meet with you, get to know your business, and then be able to explain it all to you in ways that you can understand. I think those are the qualities that if I was a business owner, I am a business owner, if I was having my business appraised that I'd be looking for and a partner who then can take that value and explain to you, like we did with that one client that came in with a $18 million, $3.5 million discrepancy and say, "Okay, well, what are the ways that you can then go ahead and increase the value of your business?"
Mark Meloy:
Great explanation. Josh, what do you have to add?
Josh Hoesch:
Yeah, Jane hit on the main things. I would say, along with expertise, I think business owners, you want to work with people that you like. You should and will spend a lot time with the firm that you go with. And so you want to like and trust those people. So I would say that's probably number one, like them. They have the right expertise in your industry, because you're going to spend a lot of time with them. Don't skimp on finding the right partner. You're going to get what you pay for. You're buying an expert's opinion that will determine a lot of next steps, right? So when you're estate planning, when you want to sell the business, their opinion's going to matter on how you structure things going forward.
Mark Meloy:
Okay. One last question. This is really for both of you. Do you have any other advice for business owners thinking about entering the valuation or selling process? Jane, I'll start with you.
Jane Tereba:
Well, I was going to say start early because the earlier you can start the better, but then also, like Josh said, don't be afraid of making the investment because wouldn't it be worth it for you to spend around nine to $10,000 to find out whether your business was worth three or 18 million? I mean, that makes a big difference in your personal wealth management, and your retirement planning, and your succession planning, and everything else. So don't be afraid of the investment and don't be afraid of the time it takes. Don't be afraid of the big laundry list of documents that are requested and the preparation that it takes to get a good business valuation. And again, the earlier you start, the more time you've got to pull all of that together.
Mark Meloy:
I think it's a great summary. Josh.
Josh Hoesch:
Yeah, I would say I think it's a good starting point, again, for making decisions both in the short term and long term. To me, it's a little bit like when you start having a family. You and your spouse, or partner, are going to want to put together a will, right? So people know you can have a baseline to work off of. I think, same with a valuation. It gives a good baseline for you to make decisions that could impact your family, impact your employees, impact your clients in the near term and long term.
Mark Meloy:
I think that's a great summary too. So many business owners really are extraordinarily loyal, especially in the Midwest, extraordinarily loyal to their employee base, and anything like this in terms of valuation, a sale, a transfer of ownership, ultimately what these lead to really have a huge impact on the lives of so many people beyond just the owner. And so I think that's reason enough for many to work early and work diligently. And as you both said, don't be afraid of the process. So thanks a lot to both of you. This has been a really great conversation. I knew it would be. Thanks for sharing your experiences, Jane and Josh, with our audience today. And to you, our audience, thanks for listening in on the conversation. Hope you found it helpful and useful as you do your own future planning for your business. Let us know if there are any other topics you'd like to hear on The First Business Bank podcast. Until next time, thanks for listening.
Speaker 1:
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