Business Evaluation Systems
BES Newsletter
July - August 2010
Business Evaluation Systems, Inc.
1700 F.M. 517 E. Suite A           281.337.1919 Phone
Dickinson, Texas 77539            281.337.1915 Fax
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Since 1973, Business Evalutation Systems has been involved in the appraisal of over 16,000 companies, covering almost every industry on a national and international basis, ranging in value from $50,000 to over $7 billion.
 
Our experience has qualified us to meet the requirements of the Appraisal Foundation, the Internal Revenue Service, lending institutions, and courts of law around the country. Two of the appraisals the company was involved in have passed the scrutiny of the World Bank. The appraisers in Business Evaluation Systems have sold over 1,000 businesses.
 
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Business Evaluation Systems, Inc.
 
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In This Issue
Business Value Drivers
Fair Value and FASB 157
Revenue Ruling 2009-13: Tax Consequences to the Original Holder of a Life Insurance Contract
 

Business Value Drivers

By: George D. Abraham

CEO & Chief Appraiser

Business Evaluation Systems

 

 

Business value drivers are those aspects of a business that can and do add value.

Today's business environment is not just about survival, it's about focusing on and creating sustainable value. But, which elements of a business are capable of creating value? Equally important which elements of a business are capable of destroying value? Proper business planning is the process of uncovering and identifying what creates and drives value.

 

Start by using the SWOT Analysis - Strengths, Weaknesses, Opportunities and Threats - this will help you identify the "value drivers" for your business. With this approach, you can focus on key value drivers.

There are many Value Drivers that have been identified in businesses. But, typically no more than 8-12 are critical in any given business; here are the most common 8.

 

Financial History:

  

Are your books accurate and up to date? Over the last few years are there patterns of growth or decline? If in decline, are there good reasons for the decline?  Accurate and current financials are important to determine how the company fares in its industry and amongst competitors.  A comparison to industry ratios can identify strengths and weaknesses in the business.

 

Management Depth: 

 

Can the company operate without the owner, for more than a week or two? Is there any cross-trained management to fill in if you were gone?  What is the average age of management?  Will they retire soon? What levels of experience and education do they possess? Having a good management team can add value to the business.

 

Customer Diversity:

 

Do you have one or two major customers that account for more than 25% of your gross sales?  What would happen to the value of your company if you lost one? Are most of your customers considered "blue chip"? A good overview and a rating analysis of the customer base can be beneficial not only for added value but is crucial for where, how and when you advertise, not to mention a much better understanding of your accounts receivable and aging. 

 

Owner Involvement:

 

Are you the 'rainmaker' in the business? Does everything from sales to production revolve around you and your decisions? How difficult would you be to replace? The more the business depends on you, the owner, the more likely the value will be lowered.  One of the things I see the most is that over the years, the business owner and number one sales person, is now an office manager.  Maybe it's time to get back out in the field with your sales people or provide on-going sales training.

 

Competition:

 

Does your company compete in a clearly defined market niche which is defensible? Or, have your products or services become a commodity that is becoming more difficult to defend?

 

Customer Satisfaction:  

 

Are your customer relationships based on great products and service, or lowest price? How long and what type of history have they had with you? Are they satisfied or loyal? Do you have systems in place to identify your customers and communicate?

 

Loyal Employees:

 

Outside of ownership, are there people in place who you can rely on and are capable of doing their job day in and day out? Are they considered knowledgeable for your industry? Again, what levels of experience and education do they possess?

 

What is the average length of employment amongst your staff? A responsible business buyer will be looking for opportunities where the current staff, especially management, will remain in place, following the current owner's exit from the business. Having key employee contracts, non-competes, but more importantly a loyal, dedicated staff that is committed to the company's success regardless of ownership change will be highly valuable to a prospective buyer and thus reflected in a business valuation.

 

Proprietary Technology:

 

Has your company developed a unique application, tool or technology as part of its ongoing operations? Does it give you a competitive advantage? If so, this proprietary innovation or intellectual property can be positioned as a key value driver for your business. Technologies or processes do not have to be patented to carry value but privacy and confidentiality must be maintained. It is critical that non-compete and confidentiality agreements be strictly adhered to and enforced by the company, before and after a transfer of ownership. The benefits, application and purpose of your proprietary technology should be explained to a business valuation consultant.

 

Intangibles (intellectual property) and human resources (who go home at night) can be protected and leveraged through a combination of business strategies and legal protections. Business strategies include incentive compensation plans to recognize, reward and retain high performing employees. Legal protections include requiring key employees to sign non-compete agreements, registering Trademarks and Copyrights, and taking steps to protect proprietary information/trade secrets such as recipes and formulas. Contracts with key players, including partners, customers and suppliers, are also important.

In conclusion, it's easy to be distracted by all the demands competing for the business owner's time and attention. To maximize the value and profitability of your company, you need to focus on the key value drivers - which may be intangibles and employees - in addition to having up-to-date equipment and systems.

Fair Value and FASB 157
 

Lady Holding Scale

 By: George D. Abraham

CEO & Chief Appraiser

Business Evaluation Systems

 

 

Fair value accounting refers to accounting for the

value of an asset or liability based on the current market price of the asset or liability, or for similar assets and liabilities, or based on another objectively assessed "fair" value. Fair value accounting has been a part of US Generally Accepted Accounting Principles (GAAP) since the early 1990s, and has been used increasingly since then.

 

 

While most accounting standards that involve fair value focus on what to

measure at fair value, Statement 157 focuses on how to measure fair value. Dispersed throughout current GAAP are inconsistent definitions of fair value and only limited guidance on application.

 

New Definition of Fair Value

Statement 157 defines "fair value" as:

 

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

 

While the definition sounds like the same as past definitions, there are some key differences.  First, the definition is based on an exit price (for an asset, the price at which it would be sold) rather than an entry price (for an asset, the price at which it would be bought), regardless of whether the entity plans to hold or sell the asset.  A second key definitional point is that Statement 157 emphasizes that fair value is market based rather than entity specific; fair values must rest on assumptions that market participants would use in pricing the asset or liability. Thus, the optimistic asset owner must be replaced with the skepticism that typically characterizes a dispassionate, risk averse buyer.

 

FAS 157's fair value hierarchy supports the concepts of the standard. The hierarchy ranks the quality and reliability of information used to determine fair values, with level 1 inputs being the most reliable and level 3 inputs being the least reliable. Information based on direct observations of transactions (e.g., quoted prices) involving the same assets and liabilities, not assumptions, offers superior reliability; whereas, inputs based on unobservable data or a reporting entity's own assumptions about the assumptions market participants would use are the least reliable. A typical example of the latter is shares of a privately held company whose value is based on projected cash flows.

 

The ubiquitous "market participant": Through the entire statement, homage is

paid to the ubiquitous market participants and what they think about risk and will be willing to pay for an asset. In effect, accountants are asked to attach values to assets/liabilities that market participants would have been willing to pay/receive.

 

Tilt towards relative value: "The definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)."The hierarchy puts "market prices", if available for an asset, at the top with intrinsic value being accepted only if market prices are not accessible.

 

Consideration of illiquidity: Accountants are asked to give consideration to specific restrictions on the sale/use of an asset in valuing it. Presumably, if there are restrictions on selling an asset, the value will have to be discounted for illiquidity.

 

Statement 157 represents the FASB's most current leaning on the age-old trade-off between reliability and relevance of financial information. Statement 157 reflects the FASB's studied conclusion that investors and creditors find fair value measurement relevant, even in the absence of solid market data. As a result of the trade off now favoring relevance, financial statement users need to be apprised of the quality of the information through the meaningful and transparent disclosures required by the new standard.

 

The principal market is the market in which the reporting entity would sell the asset (transfer the liability) with the greatest volume and level of activity for the asset (liability). If an entity has no principal market for the asset (liability), it would determine its most advantageous market. The most advantageous market is the market in which the reporting entity would sell the asset (transfer the liability) with the price that maximizes the amount that would be received for the asset (minimizes the amount that would be paid to transfer the liability), considering transaction costs in the respective market(s). Transaction costs, however, are not included in the fair value measurement.

 

Also the highest and best use of an asset will result in either an in-use premise, when the fair value is determined based on its use together with other assets as a group; or an in-exchange premise, when the fair value is determined as the price that would be received to sell the asset on a stand-alone basis.

 

Revenue Ruling 2009-13: Tax Consequences to the Original Holder of a Life Insurance Contract

 

On May 1, 2009, the IRS issued a pair of Revenue Rulings that significantly clarify the state of U.S. federal tax law applicable to transactions involving life insurance policies, including life settlements. Life settlements are a rapidly growing asset category in which investors purchase life insurance policies on the secondary market with the intention of profiting by either reselling them later for a gain or holding them until maturity. One of the impediments to the development of this asset class has been the uncertainty of the U.S. federal income taxation in this area because most of the cases and rulings predate the development of an active secondary market for life insurance policies.

  

In Revenue Ruling 2009-13, the IRS concludes that under Section 721 the original holder of a life insurance contract (the "Insured") who surrenders the contract for its cash surrender value recognizes ordinary income. The amount of the income is reduced by the sum of all premiums paid under the policy.

 

The Revenue Ruling goes on to contrast a surrender of a life insurance policy with a sale of the policy on the secondary market. The amount of the gain on a secondary sale is greater because the IRS concluded that the basis of the life insurance contract should be reduced by the amount expended for the cost of mortality protection before the sale.

 

Additionally, the IRS held that the character of the income in a secondary sale is bifurcated. A portion of the gain, up to the amount of ordinary income that would result from a surrender of the policy, is treated as ordinary income, with the balance of the gain, if any, treated as either long-term or short-term capital gain, depending on the holding period. In the case of a term-life insurance policy, the IRS assumed that absent other proof, the entire premium is used for current insurance protection and thus does not create basis in the policy. Thus, when a term-life insurance contract is sold, the entire amount of the sale proceeds generally will be taxable as capital gain.

 
 
 
Business Evaluation Systems
 

If you are interested in finding the true value of your business or machinery & equipment, we can help.  We offer fairly priced appraisals with a quick turn-around time.  Call today to find how our dedicated staff can help.

 

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