Liquidation value is not considered a principal valuation approach other than as a technique for assisting in the valuation of holding companies with investments in operating business concerns, or where a business is not viable.

The adjusted net book value of the tangible assets, while a possible principal valuation method/technique, is more frequently employed as a risk measurement aid where going concern value/price is developed pursuant to earnings/cash flow based techniques.

The going concern value of a business's net tangible assets is often referred to as its 'tangible asset backing'. It is used as a benchmark for the measurement of the going concern risk associated with the business.

Going concern value contemplates the continuance of the business operation. Therefore tangible assets are valued on a 'value in use' basis (net realizable value) rather than under a strict value in exchange assumption.

The operating assets are viewed as a pool of assets in a specific use, and their value is determined according to their contribution to the ongoing business.

Businesses normally have the perceived prospect of being able to:

Generate earnings and cash flow, and control costs relative to revenues (generally measured by profit margins ratios), and

Control the level of investment in operating assets in relation to such earnings and cash flow (generally measured by asset turnover ratios)

 

Earnings/cash flow based techniques are employed to develop going concern value where a privately-held business interest is believed to be viable as a going concern. The most commonly adopted earnings/cash/flow based techniques are;

Discounting of forecasted after tax discretionary cash flow,

Capitalization of indicated after tax earnings,

Capitalization of indicated after tax discretionary cash flow,

Capitalization of indicated earnings before interest and income tax,

Capitalization of indicated earnings before interest, income tax, and depreciation,

The dual capitalization of indicated earnings.

The going concern approach to value/price determination, among other things, is based not only on the quantum of earnings and cash flows, but on their risk of achievement and on the amount of investment in intangible asset backing required to generate such earnings and cash flow.

The definition of Tangible Asset Backing is: An amount equal to the aggregate value of all tangible and identifiable intangible assets, where the latter have values that can be separately determined, and where the value of both tangible and identifiable intangible assets has been determined under a going concern assumption (i.e. on the basis of 'value in use' as one component of going concern value, as opposed to market value or 'value in exchange' for those same assets sold on a piecemeal basis for alternate use), minus all liabilities.

A business is valued on the basis of tangible net worth at market plus a bonus for goodwill. The goodwill bonus is based on a multiplier times a typical monthly pre-tax profit after provision for a suitable owner’s salary.

Assets are valued through the tangible net worth at market calculation, which reflects the tangible assets of the business and its liabilities at their economic worth (attainable market price).

Adjusted historical income statements are examined for the most recent five years - deriving adjusted net profit before tax but after owner’s salary. The range of multipliers applicable to profits within the industry is determined, and the appropriate multiple reflecting the risk level and operating characteristics of the business is applied.

The total tangible net worth at market value plus the goodwill value determined by the multiplier is considered to represent the business value.

 

The average annual sales of a business are valued using a market-derived multiplier. However, the value so computed should be no more than the typical annual net profit (after owner’s salary adjustment) times a second market-indicated multiplier.

There is no universal formula which can be applied to all personally-managed businesses, or even to all those within a given industry classification. However, there is a universal logic that can be applied. The first element of this logic tends to set a floor on the value of the business. The second element establishes a basic ceiling.

The floor value usually is the tangible net worth of the business, with its assets and liabilities re-valued to their economic worth. Put another way, the floor tends to be the tangible net worth. If the assets do not contribute to a viable going concern, the value of assets may best be represented by a liquidation value.

While a business may evidence a reasonable living for the owner, it may produce no more. In such an instance, a prudent buyer would pay no more than liquidation value, because it seems evident the business will steadily decline and even the owner’s living will be in jeopardy. For a business to continue its existence, it must generate earnings over and above the owners living requirements. A business can not simply float. It must grow and expand and keep in step with the times. It is not unusual to find owners who ignore the prospective decline and rationalize the low profitability by stressing their independent status. Most buyers, however, do not wish to be independent today and on welfare tomorrow.

At the other end of the extreme, there is a logical ceiling to the value of the business. That ceiling is usually a price which is no more than the number of years investors are willing to await the full return of invested capital. Given the uncertainties of the future with respect to any business, including ever-changing economic conditions and constantly revised tax laws, few well-informed buyers are willing to pay for more than a few years of future profits.

In summary, the basic limits of value for personally-managed businesses are:

1. A floor of tangible net worth at market value, if the business produces enough profits to assure its owner a living and to perpetuate its existence.

A ceiling of 4-7 times pro forma profits before tax but after a salary allowance to the owner.

 

Where in between these extremes the market price falls depends on any special non-economic values the business involves, how well established it is, how profitable it is, and, particularly, how transferable its goodwill may be.

If no goodwill were involved, the pricing of personally-managed businesses would be relatively simple - determine the tangible net worth at market for the business and that would be the selling price. For many small, personally-managed businesses this approach is satisfactory, because there is no goodwill. This is true because the firm is too new, earns too little in profits, or the goodwill it has is not transferable. However, for a significant number of such firms there is transferable goodwill, and a market established formula may enter into pricing it. Or the business may change hands at the equivalent of its tangible net worth, but the market arrives at this result by a different approach.

Some of the basic rules of thumb which are widely accepted in selling businesses within the industry are as follows:

The two most important factors which affect the value of an operating enterprize are the market value of the assets (tangible net value) and the value of its earnings (a combination of the intangible assets).

If the business is making a profit, value is sometimes based upon a multiple of the gross sales (up to 50%) - income multiplier.

An investor will want to ensure that the entire investment will be returned within a three to five year period.

The above noted market formulas are merely indicators of value that buyers and sellers tend to rely upon as a starting point for negotiation.

Buyers and sellers often have opposite objectives, which tends to pull negotiations away from a set pattern:

the seller will usually wish as much of the selling price as possible allocated to goodwill because he can clearly obtain capital gain on that portion of the sale - were more of the price allocated to depreciable assets, he might realize some income that would be taxable as a capital gain,

the buyer wants as much of the price as possible allocated to depreciable assets because he can deduct depreciation each year - goodwill is not depreciable to him and offers no tax advantage.

If the buyer prevails, the business may appear to have sold for tangible net worth at market with no goodwill, whereas in fact it sold at a multiple of earnings, which included goodwill.

The pool of assets, which are made up of goodwill, and other intangible assets are categorized into three basic groups;

Group 1 - Intangible Assets Non-Severable from the Business

- the assemblage of property, plant, and equipment into a productive unit,

- the availability of trained employees,

- systems controls, and methods which have been developed as part of the operation,

- the existence of customers,

- start-up losses which have been absorbed,

- advertising and promotion accomplishments,

- advantages of location beyond those directly attributable to the real estate itself,

- the reputation established to date.

 

Group 2 - Intangible Assets Non-Severable from the Person

- the personal reputation of the owner/employees with the general public,

- the personal skills of such individuals,

 

Group 3 - Intangible Assets generally serverable from the business

- brand names, trademarks, copyrights, secret formulas, patents, franchises or licenses

 

Additional to the relative degree of severability from the business, the foregoing intangible assets have the following characteristics;

- Group 1 assets generally have indeterminable lives and must be valued as a group. Since the life cannot be fixed, the assets cannot be amortized or depreciated.

- Group 2 assets are somewhat unique in their association with individuals. In most cases they would be viewed as having indeterminable lives unless placed under an employment contract.

 

It is important to note that even though assets in all three groupings may be present in a business, this does not mean that there is any goodwill or other intangible value in the business. Usually, the business must be capable of generating a profit over and above that which is necessary to pay salaries to the owners before it is reasonable to assume the intangibles have economic value. In the absence of such profits, there must be a determinable price the market is willing to pay for them. In the latter case, this generally means the assets must be separable from the business, such as a liquor license, a water right, or favourable leasehold. Occasionally, however, an intangible premium may be paid for a losing business.

"those elements of a business or a person which cause customers to return to that business or person and which usually enable the business to generate a profit in excess of that which is required for a reasonable return on all of the other assets of the business, including a return on all other intangible assets which can be identified and separately valued".

 

Goodwill always runs with the business or individual and cannot be sold separately. If there is an excess of profits, goodwill is present. If no excess profits exist, there is usually no goodwill, regardless of how many elements of business and personal goodwill may be present.

Intangible assets other than goodwill are difficult to define in generalities because they have no single, all-pervasive quality. Intangible assets as a group are best described as being those assets of a business other than goodwill which have economic value (various kinds of rights, privileges, assemblages of data and know-how) and which can be individually identified and valued. Usually, a commercial intangible asset must either be generating an advantageous profit or it must have the likelihood of being able to do so in the near future.

The courts have generally agreed an intangible value sometimes attaches to the tangible assets of an assembled business. This is called going concern value. It may exist as a value enhancement for the assemblage of a business regardless of the business profitability. Where goodwill is usually measured by some excess profit or profit advantage technique, a going concern value might be inherent even though no goodwill or excess profit is evident - usually measured by a cost to assemble or by an unrealized return on investment.

Most of the controversy which surrounds goodwill and other intangibles is involved directly or indirectly with tax considerations - goodwill can neither be deducted as an expense, nor can it be amortized or depreciated, whereas there are many intangible assets which can be expensed or amortized as long as they are not placed in the goodwill category.

To determine the existence of goodwill one needs to examine the excess earnings and apply an Earnings Test, then look at the market test through market formula multipliers.

Earnings test:

a company may not show goodwill under the earnings test, and yet goodwill may be present in the form of going concern value,

earnings may be good, but the business has no goodwill because it has limited life due to being tied to a single contract,

the business may have no goodwill, despite its earnings, because there are only one or two customers, who can withdraw their support,

past earnings may not be indicative of the future when a key man has passed on,

the business may be faced with potentially expensive litigation which may destroy excess earnings in the future.

Market Test:

application of market multipliers to the gross sales constants and to the net profit constants for the business (the profit multiplier would set the effective ceiling price).

 

Regardless of the element of goodwill being considered, it is usually found that, as with old wine, time creates value. An individual may have special skills, but he may not be able to translate these into value over and above the normal wage for his occupation without first establishing a reputation.

A percentage return is computed on the average annual market value of the tangible assets less liabilities. The amount of this percentage return is deducted from the average annual after-tax earnings of the business (in the subject’s instance we have dealt with pre-tax earnings only).

The remainder, if any, is considered to be the amount of the average annual earnings from the intangible assets of the business. This remainder is capitalized and the result is an indication of the business’ goodwill value

JOHN D HARPER   AACI, PAg, SR/WA, CES   - personal profile