Our firm was recently retained to determine the fair value of a minority interest in a business for a shareholder dispute. Despite it being a sizable business, the owners never got around to memorialize the termination terms within its shareholder’s agreement. Hence, one of the reasons for the current litigation is to address its value. This business had grown organically over the years and by acquiring multiple competitors. It is now at a size that there are enough comparable sales transactions to consider under the market approach.
In reviewing these transactions, we noted components to the deals that needed to be considered to address its cash equivalent value. When reviewing the file, I thought of two adages learned in business school relating to the time value of money. The first, “a dollar today is worth more than a dollar tomorrow” and second, “a bird in the hand is worth two in the bush”.
How does this concept relate to business valuation?
When the value of a business utilizes the sales of comparable companies under the guideline merger and acquisition (M&A) method, it’s important to understand the cash-equivalent value of comparable transactions. Creative deal terms can make a deal more (or less) valuable than it may appear. Some of these terms may include installment payments, earnout provisions, and contractual agreements such as employment/consulting contracts and/or covenants not to compete. The following discusses a few of these issues that may affect the selling prices found within these transactions.
Installment Contracts
In some situations, the buyer may pay the seller a lump sum up front and then make ongoing installment payments over a period of time. These deals often require interest payments, as if the seller is providing financing for the buyer. Other times, interest is included within the installment payments and can be imputed based on market rates. Installment contracts are common among the sale of small to medium size businesses, particularly when a controlling shareholder is buying out a minority shareholder. Typically, installment sales are used to finance deals when the buyer has limited cash and access to bank loans. In these instances, the seller bears additional risk because there’s a chance that the buyer may be unable to make timely installment payments.
Earnouts
When a buyer is skeptical of management’s estimates of future earnings, they may hedge their risk with an “earnout” provision. With an earnout, the buyer pays a lump sum down payment, and then the remainder is contingent on the company’s future performance. The seller may receive the rest of the selling price if certain benchmarks are reached. These benchmarks could include future revenues, market share, or cost synergies. The seller may also opt to receive a set percentage of gross receipts or net cash flow for a certain number of years. This is often seen in transactions involving professional practices. These provisions can get complicated, so it’s important to define financial terms, payout limits and timing issues upfront.
Contractual Agreements With Sellers
Buyers and sellers may enter into a variety of contractual agreements, including noncompetes, consulting agreements and employment contracts. These may protect the buyer from competition by the seller or ease the transition from the seller’s management style to the buyer’s style. Sometimes, these contracts are excluded from the selling prices that are reported in transaction databases. But in other cases, pieces of a deal are bundled together and must be allocated to each component in the determination of value. In some industries, however, a non-compete agreement may be standard, and can’t really be separated from the selling price.
Adjustments As Needed
The guideline M&A method has intuitive appeal to both the layperson and professional. However, one’s enthusiasm should be tempered so to avoid blindly accepting the face value of these transactions found within the databases. It’s critical to understand each deal that’s being used as a comparable. At the end of the day, cash is king, and the true cash equivalent value of the business may need further interpolation when using certain valuation methodologies.
If you have questions about this or any other valuation issues feel free to contact me at the above phone numbers. I can also be reached via email at msgcpa@msgcpa.com
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