## Sunday, September 11, 2011

### How to Determine the Value of a Business ?

There are a number of different methods to determine a fair and equitable price for the sale of the business. The following lists a few methods to determine the price:

·         Capitalized Earning Approach: This method refers to the return on the investment that is expected by an investor.
·         Excess Earning Method: Similar to the capitalized earning method, except that it splits off return on assets from other earnings.
·         Cash Flow Method: This method is usually used when attempting to determine how much of a loan the cash flow of the business will support. The adjusted cash flow is used as a benchmark to measure the firm's ability to service debt.
·         Tangible Assets (Balance Sheet) Method: This method values the business by the tangible assets.
·         Valuing The Intangible Assets & Intellectual Properties Method:  This method also takes into consideration valuing the goodwill of the business.These intangibles may include, patents and trademarks, copyrights, mailing lists, exclusive contracts, royalty agreements, work-in-progress, proprietary designs and many others.

## Capitalized Earning Approach

A common method of valuing a business is called the Capitalization of Earnings (or Capitalized Earnings) method. Capitalization refers to the return on investment that is expected by an investor. There are many variations in how this method is applied. However, the basic logic is the same.

To demonstrate the logic of this approach, suppose you had \$10,000 to invest. You might look at different stocks, bonds, or savings accounts. You would compare the potential return against the risk of each and make a judgment as to which is the best deal in your particular situation.

The same return on investment logic holds for buying a business. Capitalization methods (and other methods) for valuing a business are based upon return on the new owner's investment.

To demonstrate the capitalization method of valuation, let’s look at a mythical and highly oversimplified business. Pretend the business is simply a post office box to which people send money. The magic post office box has been collecting money at the rate of about \$100,100 per year steadily for ten years with very little variation. It is likely to continue to collect money at this rate indefinitely.

The only expense for this business is \$100 per year rent charged by the post office. So the business earns \$100,000 per year (\$100,100-\$100). Because the PO box will continue to collect money indefinitely at the same rate, it retains its full value. The buyer should be able to sell it at any time and get his initial investment back.

A buyer would look at this "no risk" business earning \$100,000 and compare it to other ways of investing his or her money to earn \$100,000 per year. A near no risk investment like a savings account or government treasury bills might pay about 5% a year.

At the 5% rate, for someone to earn the same \$100,000 per year that the magic PO box earns, an investment of \$2,000,000 (2,000,000*5%= \$100,000) would be required. Therefore, the PO box value is in the area of \$2,000,000. It is an equivalent investment in terms of risk and return to the savings account or T-bill.

Now the real world of small business has no magic PO boxes and no "no risk" situations. Business owners take risks and have expenses, and business equipment can and usually does depreciate in value. The higher the perceived risk, the higher the capitalization rate (percentage) that the buyer will use to estimate value. Rates of 20% to 25% are common for small business capitalization calculations.

That is, buyers will look for a return on their investment of 20% to 25% in buying a small business. For some industries, buyers will often buy businesses at rates of return as high as 33% or even 50%. However, as we'll see below, some businesses have value to some buyers for reasons that have little to do with the amount of money they are earning.

Finally, it is important to point out that the return on investment does not include a fair salary for the new business owner. If the owner must devote time working to realize a profit, he or she must, in theory, be paid a fair value for that work. The owner's fair and reasonable salary must be separated from the return on investment computations. For example, if the magic PO box produced \$300,000 per year but required a manager with a fair market salary of \$200,000, the income for valuation purposes is \$100,000, not \$300,000. The fair market value for salary is the important number to use, not the actual salary to the present.

## Excess Earning Method

This method is similar to the capitalization method described above. The difference is that it splits off return on assets from other earning (the excess earnings). For example, let's suppose Joe's Ice Cream Shop has tangible assets of \$50,000. Further let's suppose that Joe pays himself a very reasonable market value salary-- the same amount that he would have to pay a competent manager to do his job. After paying the salary Joe's business has earnings of \$120,000.

The \$50,000 in assets that will be included in the sale include items such as freezers, inventory, and store fixtures. The buyer's expects to be able to obtain a bank loan for the \$50,000 fair market value, secured by those assets at 8%. The rate used in calculations is usually adjusted up by 2-3% from the rate that the bank charges, so we'll use a rate of 10% in this example.

This \$6,000 excess earning number is typically multiplied by a factor of 1 to 6 based on such subjective factors as the level of risk involved in the business, the attractiveness of the business and the industry, competitiveness, and growth potential. The higher the factor used, the higher the estimate of the business will be. An average number is 3. That is, a business that is judged to be very average in terms of the level of risk involved, the attractiveness of the business, the industry, competitiveness, and growth potential would use three as a multiplier. The actual factor used is a mix of opinion, comparison to others in the industry, and industry outlook.

We have built a free valuation calculator located at www.freevaluationsonline.com it will ask a series of questions to determine an appropriate multiple for your business. A more detailed analysis, that accounts for many more of the non-financial factors that affect the value of a business is available at valuationsllc.com/valuation. If you want our professional judgment look at our website for more comprehensive valuations at http://business-valuation-services.com

Let's suppose that Joe's business is a bit better than average in these factors and assign a multiplier of 4. Therefore, the value of this business can be determined as follows:

 Fair market value of tangible equipment \$50,000 Total Earnings \$120,000 Minus carrying cost of Tangible assets \$50,000X10%= -\$5,000 Excess Earnings \$115,000 Value of excess earnings \$115,000X4= \$460,000 Estimated Total Value \$460,000

*An alternative approach to using a rate 2 to 3 points above the current bank rate for a small business loan, or about 5 points above the current prime rate is to find an industry appropriate rate for return on assets.

The capitalization methods work for businesses that derive their income primarily from tangible assets such as a utility (gas or electric company). In the case of most small businesses that earn only a small part of their revenues from tangible assets, the excess earning method is probably a better method to use.

Value The Intangible Assets & Intellectual Properties Method

Examples of Intangible Assets:
What are Intangible Assets and Intellectual Property ?
Intangible assets or intellectual property are the “brainpower" that formulates the product to be produced whereas the tangible or physical assets are the "strength" that are actually involved in the product’s production.

Intangible assets fall into four broad categories, they are: Market Related, Customer related, Contractual and Technology related intangibles.

How To Value Intangibles Assets and Intellectual Property ?
There are three primary methods to value intangibles: the Income approach, the Market Comparable approach, and the Cost approach. Numerous modifications of these approaches have been developed over the years. The value of an intangible may be based on using one or various combinations of these approaches.

Reasons to have a valuation of Intangible Assets and Intellectual Property
• An intangible asset and purchase price allocation appraisal should be performed when accounting for business combinations under ASC 805.
• For a Transfer pricing study Asset Valuation (IRS Section 482) or royalty rate study which involves licensing of an intangible asset such as a trademark, patent or technology.
• An intangible asset valuation should be performed in order to comply with the goodwill and other intangible assets impairment testing requirement of ASC 350.
• An intangible asset valuation should be performed when accounting for the impairment or disposal of long-lived assets under FASB 144
Remaining Useful Life of Intangible Assets or Intellectual Property
For Fair Value financial reporting purposes, the remaining useful life determination of intangible assets is required. Estimating the useful life is important in determining the value. Generally the longer the life, the more valuable the intangible asset.

For IRS Federal income tax purposes, the remaining useful life determination of intangible assets and intellectual property is as important as the appraisal. The Internal Revenue Service allows for the amortization of intangible assets only when the taxpayer establishes that the assets have an ascertainable value separate and distinct from goodwill, and have a limited useful life whose duration can be ascertained with reasonable accuracy. In order to prove that these intangible assets are wasting and have a reasonably determinable useful life, we perform an obsolescence, decay and lifing analysis.

Valuing Intangible Assets
By Benjamin P. Foster, Robin Fletcher, and William D. Stout
In Brief

Establishing Practices in an Emerging Area
Recently issued accounting standards have created the need for valuation of intangible assets for financial statement purposes. Arriving at these valuations can be a complicated and uncertain process. Although the standards address only those intangibles acquired in a business combination, they raise the question of what values remain hidden within internally developed intangibles.

The variability of such assets is evidenced by the declines of dot-com companies whose reported assets could have never accounted for their market valuation highs. As business evolves, however, more reliable means of valuing intangible assets—such as a bank’s valuation of intellectual property to be used as collateral—are becoming more common, and someday may become the norm.

In recent years, three factors have changed the way financial statement users view intangible assets, especially intellectual property (IP): newly issued financial accounting standards, the rise (and fall) of many companies whose main assets were intangible, and the increase in objective external evidence of the value of IP. The business environment’s evolving view of intangible assets has significant implications for accounting for and valuing these increasingly important items.

Accounting for Intangible Assets
SFAS 141, Business Combinations, addresses accounting for intangible assets acquired in a business combination. SFAS 142, Goodwill and Other Intangible Assets, addresses accounting for the acquisition of intangible assets outside of a business combination. SFAS 142 also addresses the accounting for all intangible assets following their acquisition. Neither standard, however, addresses the reporting of internally developed intangible assets.

Business combinations. SFAS 141 requires an acquiring entity to allocate the purchase price of an acquired entity to the assets acquired and liabilities assumed at their estimated fair values on the date of acquisition. The standard provides the following guidance:

An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations). If an intangible asset does not arise from contractual or other legal rights, it shall be recognized as an asset apart from goodwill only if it is separable, that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so).

Appendix A to SFAS 141 provides examples of intangible assets that might be recognized separately: trademarks, Internet domain names, noncompetition agreements, customer lists, books, advertising contracts, construction permits, use rights, employment contracts, patented and unpatented technologies, and secret formulas.

Once the acquisition cost has been allocated to acquired assets (including intangibles) and assumed liabilities, any remaining amount is then recognized as goodwill. Continuing current practice, SFAS 141 requires acquired research and development assets recognized as part of a business combination to be immediately expensed if they have no alternative future use.

Post-acquisition accounting. SFAS 142 addresses accounting for all intangible assets (including goodwill) after their acquisition, including those acquired in a business combination. The most significant change brought about by SFAS 142 is the elimination of goodwill amortization. In its place, SFAS 142 requires companies to conduct annual (in some cases interim) tests for impairment of goodwill.

The standard calls for a two-step impairment test. First, the fair value of a reporting unit is compared to the carrying amount, including goodwill previously recognized. Second, the implied fair value of the reporting unit’s goodwill is compared to the carrying amount of the goodwill. If the fair value is lower, it is considered impaired.

Accounting for other intangible assets is more straightforward. The asset is amortized over its useful life using a method that reflects how benefits of the asset are consumed. SFAS 142 permits the use of the straight-line method if no other pattern can be reliably determined. Managers should evaluate the useful life each reporting period, and report adjustments as a change in accounting estimate prospectively over the remaining useful life. Perhaps, under SFAS 142, managers could incorporate the use of appraisals if they can show that appraisals of intangible assets are reliable and reflect the pattern under which benefits are received better than the straight-line method.

Accounting and the New Economy
Recently, many companies’ GAAP stockholders’ equity per share has been significantly lower than the price per share as traded on stock exchanges. For example, Microsoft reported stockholders’ equity of about \$68 billion in recent financial statements, yet its market value at the filing date was approximately four times that amount.

Critics of the current financial reporting model cite the failure to report the value of certain intangible assets as a cause of these differences. Those critics say that GAAP must consider the values of these increasingly important, currently unrecognized assets in financial statements.

Electronic Business recently published an article titled “The Reporting Gap: Earnings and Other Financials No Longer Suffice as Measures of Corporate Health” (Roberts, 2001). According to the author, accounting practices that prohibit the recognition of intangible assets are the main reason companies’ GAAP-based balance sheets do not reflect their true worth.

In the April 7, 1997, Forbes, Baruch Lev stated, “How ironic that accounting is the last vestige of those who believe that things are assets and that ideas are expendable.”

In the November 1999 Strategic Finance, King and Henry said that the intangible assets of many high-tech companies “walk out the door every night.” King and Henry further lamented that GAAP does not allow the value of such intangible assets on balance sheets, and called for change.

These criticisms of current reporting requirements for intangible assets appear to be based on the premise that the balance sheet should show the value of a company’s assets. Accountants and most sophisticated investors, however, recognize that the book value of a particular asset on a balance sheet may have little relation to the actual value of that asset.

In addition, a variety of definitions of “value” exist. FASB has struggled with this issue and has promulgated some accounting standards that attempt to reduce the difference between reported values of assets and liabilities and their fair values in the marketplace. For example, investments in marketable securities are generally recognized at fair market value on the balance sheet date.

Derivative instruments are also reported at fair market value, as is long-term debt in certain situations. SFAS 141 applies the fair value approach to intangible assets acquired in business combinations.
The balance sheet undoubtedly has significant limitations in terms of reporting an entity’s true value. Internally developed intangible assets, even those for which a fair value may be determinable, are not recognized in the financial statements.

Other intangible assets, such as political clout and regulatory expertise, are generally not even discussed in company reports. Investors and creditors recognize these limitations, and presumably perform independent research and analysis in their investment and credit decisions.

The Intangible Asset Quandary
The two recent FASB standards do little, if anything, to help investors better evaluate this aspect of businesses. Some critics argue that currently unreported internally generated intangible assets should be reported at fair market value, just like those acquired from outside the entity. But doing so will require companies to incur potentially significant costs.

Hiring appraisers and value analysts to determine the fair value of intangibles may be somewhat costly, but the extra risk incurred by executives and auditors may be extreme. Given that the value of intangibles can fluctuate wildly over time, will financial statement users perceive that the values reported previously were incorrect or perhaps even fraudulent? Will company executives and external auditors be exposed to additional liabilities?

In late 1999, Ask Jeeves, Inc.’s common stock sold as high as \$180 per share. At that price, Ask Jeeves’ market value was nearly 200 times stockholders’ equity. The indicated market value was approximately \$4 billion, but the company’s balance sheet showed assets of only \$32 million, the bulk of which was cash, cash equivalents, and investments. Investors evidently thought that Ask Jeeves possessed significant intangible assets.

Less than 18 months later, the stock sold for about \$1 per share, with an indicated market value of \$50 million. Apparently some of the company’s assets “that walk out the door every night” failed to return the next morning. If the company had reported substantial intangible assets in 1999, would executives and auditors have been exposed to charges of fraud in 2001?

Recent stock market performance makes it easy to find companies whose market value has significantly declined over relatively short periods of time. One could argue that the recent fluctuations in market value indicate that measures of intangible assets are inaccurate and unreliable. Fluctuations in the value of certain assets, however, are not an adequate excuse to ignore real and potentially substantial assets.

External Evidence for the Value of Internally Developed Intangible Assets
Recognizing (or even disclosing) the fair value of currently unrecognized intangible assets has at least two major drawbacks. First, determining fair value saddles the reporting company with new, unrecoverable costs.

Second, the lack of objective evidence of value (such as acquisition cost in the case of a business combination) potentially exposes executives and auditors to increased liabilities should those valuations turn out to be incorrect. Two sources of external evidence on the value of intangible assets have, however, been largely ignored.

Intangible assets as collateral. The first source of external evidence on the value of unrecognized intangible assets is the willingness of lenders to accept such assets as collateral for loans. In a report by Reuters in September 2002, Rozens reported that one bank, UCC Capital, has developed a niche by lending money for bonds secured by companies’ regular income from patents or fashion logo licensing.

Also, King and Henry point out that major banks have made loans to corporations secured not by traditional assets, but rather by trade names and patents. In at least one case, a bank accepted specific intangible assets as collateral, and determined the value of these assets by appraisal.

Using intangible assets as collateral can temper the two major drawbacks of reporting the value of currently unrecognized intangible assets. If the cost of the appraisals is evidently not significant enough to prevent obtaining bank loans, why should appraisal costs be an issue for reporting to all investors and creditors? Interestingly, annual appraisals are required in the case King and Henry describe.

The second drawback is the reliability of the information and the potential for increased liability for executives and auditors. For a bank to accept intangible assets as collateral based on appraisals indicates that it is satisfied with the reliability of the appraisal. (Of course, the bank may lend only a fraction of the value of the intangible. The absolute reliability of the appraisal may not be as important for a particular bank loan as it would be in overall financial reporting.)

Insured values of intangible assets. The presence of insurance for intangible assets also offers objective external evidence of their value. Insuring individual intangible assets, or portfolios of intangible assets, began in the mid-1970s, and such insurance was offered to cover infringement litigation expenses in the 1980s. Protecting IP from or through litigation is costly. A goal of litigation insurance is to address the needs of small companies owning IP.

Many small companies experience difficulty penetrating markets because they cannot afford the expense of IP litigation encountered when facing competition from large companies that have extensive access to IP legal services. Companies without adequate resources or insurance may not be able to enforce their IP claims against larger competitors. Small companies may also not be able to adequately defend against allegations of IP infringement, whether or not those allegations have merit.

Insuring IP against other forms of loss was a natural extension of IP litigation insurance. The potential losses that threaten the value of IP include infringement, loss of royalty stream, invalidation, unenforceability, or loss of ownership. The amount at risk is the IP value itself, which is based on factors such as income, competitive advantage, and other intangible benefits generated by the IP.

Thus, a formal valuation taking into account all relevant factors regarding an item or portfolio of IP is required to insure its value for a specific amount. The dollar amount determined for IP in the formal valuation may be the amount to be insured. (The value of IP used for collateral on loans could also be insured, providing protection to lenders.)

The fact that insurance companies are willing to accept and insure the risks that companies face with IP, and that lenders face from collateralized loans, provides external evidence that an intangible asset has value. If a company chooses to insure its intangible assets, disclosure of the practice and the insured values could provide useful information to creditors and investors. The value they are willing to insure could be used for purposes of lending, borrowing, or financial reporting. Such a disclosure could help bridge the gap between reported values and market values.

Intangibles and GAAP
Appraisals are used to determine the value of intangible assets used as collateral for loans. Appraisals are also used to determine the value of intangible assets, especially IP, to be insured. The fact that IP is used for collateral on a loan or as an insured value is important in valuing such assets acquired through a merger under SFAS 141.

The records of an acquired company for appraisals related to the use of intangible assets as collateral for loans or insurance of intangible assets could provide valuable evidence for the existence and valuation of intangibles. In most instances, such items should be separately recorded as assets resulting from the business combination.

SFAS 142 permits the use of the straight-line amortization method if no other amortization pattern can be reliably determined. Annual intangible asset appraisals used to determine values of collateral for loans and values for IP insurance may be another way to reliably determine amortization.

Application to future GAAP. In the long run, external evidence could help allow internally developed intangible assets to be included in financial reports. Initially, companies might voluntarily report these appraised values in the notes to their financial statements.

If research determined that such disclosures were useful to investors, and if the valuation costs had already substantially been incurred, then FASB could consider recognizing those values directly in the financial statements.

Assets disappearing overnight, however, raises the issue of the need for a new scope for the definition of loss. Intangibles are not lost to tangible threats such as fire and storm. Intangibles are at risk of loss due to intangible forces, such as changing overall economic conditions, increased competition, new technology, and employment changes.

Accountants have long addressed asset value risks. Some of the same forces that can cause intangible assets to lose value can also affect fixed assets. SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, addresses issues related to such declines in the value of tangible assets. Future standards regarding the reporting of internally generated intangible asset values could also specify how inevitable fluctuations in value should be handled.

Prepared by CAMFinancialmarket
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