Armando (0:00 – 1:28)
Hi, I’m Armando Roman, host of the Founders Guidepost. You’ve built your business over decades and now it’s time to think about that once-in-a-lifetime exit. You’ve come to the right place.
Here, you will hear business exit professionals talk about what you should know before exit. Besides hosting the Founders Guidepost, I’m CEO and founder of Axiom Founders Family Office, a Scottsdale wealth management firm helping founders and their families preserve their American success story. We oversee and coordinate a network of vetted professional advisors to help maximize their probability of achieving everything that is most important to you.
And we host the Scottsdale Founders Forum, a biannual live event for the founder considering exiting in the next 36 months. Here’s to your hard work and your American success story. Enjoy.
Hi, Armando Roman with the Founders Guidepost here today with Lynton Kotzen, who was formerly Kotzen Valuation Partners, now a part of JSL, a much larger organization. And Lynton, I’m very excited to have this conversation with you. You are known here locally in Arizona as the valuation person.
And if anybody has questions about what their company might be worth and how that happens, you’re the go-to guy in that space. That’s how I know you here locally in Arizona. Does that sound about right?
Lynton (1:29 – 1:32)
Yeah, I appreciate the kind words and the introduction. Thank you.
Armando (1:33 – 2:21)
Certainly, certainly. So, Lynton, people don’t come see you till they realize that they need your services. And most of the people who we’re talking with in our firm here, they’re founders of a business.
They’ve had one company, maybe 20 or 30 or 40 years. And they’re looking at that next stage of their life and transitioning this business into the next person’s hands. They, through blood, sweat and tears, built this company.
And now they’re not quite sure what exit is best for them personally, and what transition to the next ownership is best for the company and the people in the business. So, can you speak to what it is you typically do for a business when you’re going through valuation, what that really means, what it is, how it works, just in the big picture?
Lynton (2:22 – 16:34)
Sure. And I’ll start off really at a broad level. And then if you need me to drill down into any of the specifics, happy to do that.
But as I often tell clients when they call me, is if you own a share of Microsoft and you decide that you want to sell it, you call your broker. Well, I guess you would do that in the old days. Nowadays, you’d go online and you’d basically sell, execute a sell order, and you’d have cash in your account in three days.
The problem with most privately held companies is there’s no active market. You can’t call your broker, go online and say, I want to liquidate my investment in XYZ company. So, they have to hire someone like myself that goes through a process to determine what the value of the company is based on an assumed hypothetical transaction.
At what point or what equilibrium point would a buyer and seller come to some agreement, some meeting of the minds as to what the seller is willing to sell the company for and the buyer is willing to buy the company. Now, the process is not done in a vacuum. As I tell people, it’s what we refer to as it’s a top-down approach.
So, you need to really understand the economic trends, the economy that the company operates in, how that impacts the value of the company. Also, the industry that the company is in is going to have a big impact on value. What is the outlook for the industry?
Is it on the uptrend? Is it on the downtrend? Is it in a growth cycle?
Is the industry stable? Is there a rapid growth trajectory ahead for the company? Then you drill down into the actual specifics of the company, looking at their historical financial information, profitability, revenues, the balance sheet, the quality of assets.
And once you’ve done and gone through that, the quality of management, is there management depth? All of those things to determine what is the overall risk profile of the company. And at that point, you’ll determine or go through a process of determining the value.
And there’s essentially three, what we call, approaches to value. Any valuation that you perform, you would go through and apply these three standard approaches to value. And what I’ll do is I’ll just start off again fairly broadly and just give some description of what these approaches are, just to put it in context.
And I’ll start with what we call the asset approach. So that really looks at the company’s balance sheet, looks at the assets, less liabilities, and that gives you the company’s equity. And so let’s just add up all the assets, deduct the liabilities.
Let’s just use a hypothetical example. There’s $10 million of assets and $4 million of liabilities. So the equity of the company is $6 million.
The problem is that most companies, their most valuable assets are intangible assets that aren’t reflected on the balance sheet. So if you value a company based on an asset approach and just looking at tangible assets, you’re probably going to undervalue the company because that approach isn’t going to incorporate or include all of these intangible assets that have been internally developed over a period of years. And just what are examples of those intangible assets?
Well, it’s the relationships, the know-how, the management depth, the assembled workforce, that assemblage of all of these assets that are generating profit. And those assets have value. As I said, those assets, because most of the time they internally developed and generated, they don’t get recorded as assets on the balance sheet.
So if you apply an asset approach to a profitable, growing company, you’re going to be undervaluing the company. So you rarely would apply an asset approach, but you still have to go through a process of looking at what the underlying assets of the company are, because typically that’s looked at as a floor to value. So the value shouldn’t be less than what the net assets of the company are.
So in that prior example, the value shouldn’t be less than $6 million because you can go out, collect your receivables, pay your liabilities, and distribute the remaining $6 million to the shareholders. So that would establish a floor to the value of the company. And then so the next approach is what’s often what we refer to as a market approach.
And that’s very similar to if you’re buying a house or selling in the house, the realtor would go out into the market and look at comps or comparable sales of similar companies in your subdivision or your neighborhood and determine, well, what are these types of houses selling for on a per square foot basis, and then extrapolate that to come up with a value for the house. Well, that works fairly well when it comes to a real estate asset. But when you’re valuing companies, there’s a lot of difference between different companies in the industry.
So it’s not often that you can find an exact comparable for your company that you can look to. But you would go through a process. There’s databases that essentially track the sale of private companies.
So you would look at companies in that industry and see what people are paying for similar companies in actual market transactions. So the benefit of a market approach is it’s based on actual market transactions of theoretically comparable companies. And there are a lot of issues with applying the market approach, which I’m not going to get into now, because I just want to really touch on the different approaches.
Another approach under the market approach is what we refer to as the guideline company method. And that’s looking at publicly traded companies that are in a similar industry and seeing how the market values those companies and calculating multiples of revenue, multiples of profit, multiples of cash flow, and then applying those multiple that public companies are trading at and applying those two to the subject company. There’s also a lot of issues that need to be considered before you can actually relate those multiples for large publicly traded companies back to the subject company.
But you will look at how are companies like this valued in the public markets. So if similar companies are valued at six or seven times earnings, then you would expect the value to come in or reconcile back to that data point that’s being derived in the public markets. And that’s how buyers and sellers of stocks in that particular company have valued the company and are willing to buy and sell the security of that public company.
So that’s really the guideline. That’s really the market approach. There’s actually one other method that you would look at under the market approach, and that’s looking at prior sales of the subject company.
So if there have been recent transactions involving the subject company, you would look at what people have paid for the company or for shares in that company based on recent transactions. And that’s a fairly relevant data point. Assuming that those were between unrelated third parties, everyone acting on an arm’s length basis, then that would give you also an additional data point, because now you have an actual transaction involving the subject company.
The final approach and the approach that’s probably used most often when you value private companies is what we call the income approach. And that’s looking at how much cash flow is the company generating and what would someone pay for that stream of future cash flow. So you would calculate a discount rate or a multiple, and you would apply that to the company’s cash flow based on an analysis of what the company’s done historically, and then also what they expected to do or generate going forward.
And then you would apply the discount rate, you would discount those future cash flows to come to a value. So that’s the income approach. And that’s probably the approach that gets used most often to value private companies.
And then you would use these other approaches that I mentioned to make sure that the income approach is giving you a reasonable indication. Because theoretically, all these different approaches should triangulate into a neat range. But oftentimes, you’ll have very disparate indications from each of these different approaches.
And you can’t just take an average of, you know, the high and low and say, okay, you’re going to take something in the middle, you need to understand which of the approaches is the most meaningful, and put probably the most weight on that approach that’s giving you what you as an appraiser or valuation professional think is the most reasonable indication. As I often tell people, value needs to be, you know, reasonable. And you would look at it relative to, you know, if we value the company, and we’re valuing it at 10 times, you know, cash flow, and similar companies are trading on the public markets, and selling in actual market transactions at six times cash flow, then there’s probably something wrong with your valuation, you’re going to need to be able to reconcile why the value is so much higher than what actual transactions of similar companies, or how similar public companies are valued in the public markets. So hopefully, that gives you kind of some perspective of, you know, what we’re doing, and how we do it.
So just to summarize, it’s a holistic approach, it’s really looking at it from a top down company is subject to economic and is subject to the economic and industry trends, based on the economy and industry that it operates in. And also, the more profitable the company, the higher the growth profile, the less competition, all of those things make the company less risky, and the lower the risk, the higher the value. You know, value really comes down to three variables, essentially, it’s profitability, growth, and risk.
And the risk is really what’s reflected in the discount rate. So you want to estimate, well, what’s future cash flow, how risky is that cash flow? And how much is that cash flow expected to grow by, you know, in the future.
And valuation is a forward looking analysis. But you have to do the historical analysis. Because in order to see where the company’s going, you really need to understand where it’s been.
So you have to do that historical analysis to be able to project where you see the company going in the future. But value is kind of a forward looking and forward looking analysis. And then just, you know, a lot of industries that have, you know, been really popular, really valuable, really profitable, you know, one day, and then we’ve seen those types of industries, you know, disappear overnight.
But one of the examples I always use is Blockbuster. Because, you know, back in, you know, early 2000, I did a lot of work for Blockbuster. And they were doing really well, you know, very highly valued, very profitable company, publicly traded, the share did really well.
And we’ll know what happened is, you know, Blockbuster made a strategic decision that proved to be their downfall is they didn’t believe that things would be streamed. They thought that people would always go into a video store, take a video and go put it in their VCR machine. And that’s how movies would be disseminated.
And that’s not what happened. So if you look around, you know, there are not many Block, there are no Blockbusters that I know of that exist. And what I always tell people is most of those Blockbusters in Phoenix anyway, are now urgent care centers.
So, you know, that’s a good example of an industry or a company that was doing really well, and became obsolete over time. You know, Kodak, and, you know, digital photography, and, you know, all of those things are important to understand when you’re building a company. And that’s why the industries, the industry analysis is important.
And you need to analyze a company, not in a vacuum, but based on what’s happening in the industry that the company operates in. Because if the industry is trending down, then the company probably, that would be reflected in the company’s value. Whereas if the industry is on a steep upward trajectory, there’s probably going to be a lot of additional value, because there’s a very high future growth profile for that company.
And the higher the growth profile, the higher the value is going to be. The less risk, the higher the value is going to be. The more profitable and the higher the cash flow is, the more valuable the company is going to be.
Armando (16:34 – 17:09)
Well, so Lynton, I can see that a lot goes into, of course, what you do to get that, like I said, that range of values for the, you know, for the work that you’re doing. The question that comes to mind for me is, and it seems like when a buyer and seller are having conversation, and maybe neither is really sure what that value is, do you get called in at times to do your work? And that helps them have some more metrics to talk about and help them determine value?
Or when is it that people will call you because they need your services?
Lynton (17:10 – 19:39)
Well, often we get called, you know, for your particular, your client profile that you, you know, mentioned at the beginning of the call. We’ll get called by one of the client professionals, an attorney or a CPA, saying that their client just got an unsolicited call from someone that’s interested in buying the company, and they have no idea what the company’s worth, and they want to hire us to do a valuation. And what I always tell people in that situation, our valuation should be used as a basis to assess the reasonableness of an offer that’s going to be made by the buyer.
You would never take that valuation and go to the buyer and say, I want you to pay me x based on the value. You use that value to assess the reasonableness of the offer, because hopefully someone’s going to pay you some premium over what our value would indicate. Because we’re always doing our valuation from the perspective of what we call a financial buyer.
But a strategic buyer, which is another group of buyers that’s out there, may pay a premium over what a financial buyer would pay. Even though from a strictly theoretical standpoint, a buyer shouldn’t pay the seller for the synergies that they’re bringing into a transaction. But based on my experience, and I see this all the time, that people come in and overpay for companies because they’re anticipating or expecting synergies that ultimately never get realized.
And as I often say, synergy is a very overrated concept. But we get brought in and as I tell the sellers in that context, use us to educate you on valuation. So when you receive that offer from the buyer, then we can look at it relative to where the valuation is.
Because I’m not going to feel bad or be embarrassed if their value is higher than ours. But to the extent that the offer is lower than what our valuation is, at that point, we would use the valuation to try and understand why they’re paying less than what our value is. And we often will get contacted by people that are looking to sell their company.
And we always tell them, if you’re going to sell your company, you want to find a strategic buyer, because a strategic buyer is going to pay you the most amount of money for your company.
[Speaker 3] (19:39 – 19:40)
Okay.
Lynton (19:40 – 21:03)
You want to hire someone that’s going to be able to go out there and find that strategic buyer that’s going to be willing to pay you a premium over what the financial buyer would pay, because the financial buyer is going to pay you based on what the existing cash flow of the company is. A strategic buyer may be buying your company as part of a roll-up, or they may have a similar company in another geographic market and are looking to expand geographically, so they don’t really need all of your corporate overhead, because they could absorb a lot of that into their corporate overhead. But when they’re looking to acquire, they’re really looking at a different cash flow to what your company is on a standalone basis, because they could get rid of potentially a big chunk of your corporate overhead by absorbing this business into their existing structure.
There are a lot of moving pieces, and that’s something that really needs to be understood. But some people are proactive, so we often will get contacted by people that are thinking of a potential sale and are hiring us to look at what value is and advise them or assist them in ways that they could enhance or increase the bet.
Armando (21:03 – 21:28)
Okay. And I wanted to ask you about that. When you’re going through the process, going through your work, when that owner, that leadership team is talking with you, the ownership team, whatever that might be, you’re also able from your lens to help them look at what metrics could change or what they could make differently to increase the value of that company.
Lynton (21:29 – 23:17)
Yeah, absolutely. There’s certainly what we call like levers or value drivers, and just helping companies understand that there’s certain things that they can do to enhance value. You want to make sure that if you’re thinking of doing a sale, the cleaner the financial statements are.
When I say clean, I mean, there’s not a lot of personal non-business expenses being run through the company that are going to need to be adjusted or added back in a sale where you’re going to have to sit down and explain to the buyer about certain expenses that shouldn’t really be there on a prospective basis. It’s better to clean up the books and records and maybe get audited financials and make sure that there’s going to be less add-backs. So, when you’re having that discussion with a prospective buyer, you have the reported income, and then you have the true economic income, and you’re making adjustments or what we call add-backs to go from what’s being reported to what the true economic income is.
If you were operating this business with the goal of maximizing profits and not potentially trying to minimize taxes, there would be a different income and you really want to make sure that you can bridge the gap and operate the company and have an infrastructure in place that’s there to support the future operations. Because often, there’s not a deep management team. The company is totally reliant on the owner and one or two key executives.
So, you need to diversify and have a good management team, a strong bench.
Armando (23:17 – 23:35)
Are you wondering if you’ve missed anything in your planning? We hear that a lot from very smart, very successful people. And that’s why you may be interested in our Founder Stress Test, even if you’ve already sold your business years ago.
For more information, go to axiomcorp.com.
Lynton (23:36 – 25:13)
Because often, some of the buyers, especially private equity buyers, they’re not coming in to manage the company. They want to make sure that there’s strong management and a deep bench in place that can continue to manage the company. And it’s not dependent or reliant on one individual because that makes the company more risky.
And as I said, the higher the risk, the lower the value is going to be. The more diversified the management team is and the less dependent or reliant they are on a key management individual, the less risky the company is. And that’s going to increase value.
If there’s extreme customer concentration, you want to make sure that you diversify that customer base. Because if 85% of your sales are to one customer, there’s no real customer diversification. And that’s going to make the company more risky, which is going to lower the value.
And sometimes, it’s hard to avoid that. Defense contractors, for example, their biggest customers, in most cases, the Department of Defense. So there’s no real issues about non-payment because the Department of Defense is always paying for service, but you are already fully dependent on that one client.
And the less customer diversification there is, and the more eggs there are in that single basket, that makes the company more risky and higher the risk, the lower the value.
Armando (25:14 – 25:28)
So, Lynton, what are some of the common things you hear from the owners of the business as you’re going through your work and presenting to them what the final range of values is? What are some common surprises that you help them understand?
Lynton (25:30 – 27:14)
Well, often, really, when you start asking questions and really drilling down and asking things about customer concentration, management depth, supplier concentration, these are questions or things that they’ve never really thought of. It’s an educational process to them as well. And that’s what I always try and tell them is, you know, if you don’t learn something from this process, then, you know, we’ve done something wrong because it’s not a black box.
You know, we want this to be interactive. We want you to understand, you know, what drives value and then what you can do to enhance value over time. So I think what you can see, so often we get brought in at the last minute where there’s this mad scramble because they’ve received, you know, this unsolicited bid and the transaction’s moving really quickly and they’re trying to understand and learn about value.
And, you know, those are much more stressful. But then you also have those people that recognize early on that they want to do some kind of an early transition of ownership. And there’s different ways of doing it to existing employees and ESOP, family members, sale to third parties, but they, you know, want to get in early and they’re more proactive.
So they’re looking at, you know, what’s the current value? What do we need to do to move, to pull those levers that are going to increase value? Because it is a process.
And if it’s properly managed and done properly, you can increase value and enhance the ultimate proceeds that you’re going to get from.
Armando (27:15 – 28:05)
Okay. So I spoke with a business owner recently who received an unsolicited offer, $30 million for the business that he’s had for 25 years. And that’s a good chunk of money.
And it was very tempting to him. He’s not gone through a sale before, just doesn’t know what he doesn’t know. And some, you know, others I’ve spoken with in his same boat have said, you know, why would I go through and pay for an appraisal?
Why would I go through and hire a broker? I’ve got an offer for $30 million. Sounds good to me.
I’ll take it. And then hire the lawyer, get the deal done and it’s done. So when someone does that versus talking with you, an expert in space who does this day in, day out, what is the real risk or opportunity cost or the loss for that owner by not going through that process?
Lynton (28:06 – 30:55)
Well, I think that they want to understand, is this value fair? Because yeah, $30 million may be a fair chunk of change, but it may actually, the company may actually be worth $40 million or $45 million. And often when you hire a broker or investment banker, you go through a process where you’re getting multiple people to come in, look at the company and you create a competitive bidding situation.
So a single bidder, you may not get the best and highest value by having one bidder. If you can create a competitive bidding situation, there may be other people out there that may be willing to pay a premium. So a lot of times where we have been through transactions and I’ve seen that evolution, it’s people hiring a broker or investment bank that will go out and shop the company and get multiple bids and then create this competitive bidding situation and ending up with a value.
And sometimes they won’t take the highest value. They’ll look at match and look at employees and see who is least likely to cut all the overhead and fire a bunch of employees. So sometimes people aren’t only motivated by the ultimate sale price, but they want to make sure that there’s going to be security for the employees and they want to make sure that it’s a good fit.
So the only way you can really know if you’re getting the highest and best offer is to engage in a competitive bidding situation. And it may ultimately end up that that initial offer is the highest and best offer. And you’ve gone through a process where you’ve spent some additional money trying to get back to the same point.
But at least you’re not going to second guess yourself down the road when you hear four months later that one of your competitors sold his company for $40 million and then be scratching your head and say, well, why did I only get $30 million? I think you at a minimum need to go through a process to understand, well, is this fair? And one of the issues as well, I always say there’s two components to any transaction.
A is the value and B is the terms. So is it an all cash offer? Is it an earn out?
Is the buyer giving us stock in their company that has all kinds of restrictions? Are there onerous employment agreements and non-compete agreements? There’s a whole litany of other issues that come with a transaction and it needs to be properly analyzed from all those different aspects.
Armando (30:56 – 31:44)
And that makes a lot of sense. That makes a lot of sense. It sounds like I spoke with another owner recently also who has a management team, seems to be a very strong management team who’s been there.
They know what their jobs and responsibilities are. They run the company and he pretty much now functions pretty much as an absentee owner. Checks in and looks at things happening day to day and can see the metrics and see where things are, which from what you’ve described sounds like someone who has done that with his company might be able to get the highest price for it because he has a fully functioning, kind of a self-sustaining business where if the owner steps away, the business continues without him just fine.
Lynton (31:45 – 32:39)
Yeah. And in that situation there is kind of what I call is the management depth and there’s a lot of continuity within the management team that makes the company in my mind less risky. So that should be more valuable in a similar company where there’s one owner that’s wearing multiple different hats, that’s working 100 hours a week and controls everything because if anything happens to that individual, there’s no backup.
The company is going to quickly implode. So because there’s less management depth, that company would be considered more risky and that should result in a lower valuation and a lower multiple than someone would be willing to pay because that company is clearly more risky than your company that you had mentioned before. It has that management depth and a functioning management team.
Armando (32:40 – 32:50)
Are there, Lynton, are there common things that the founder can do to increase value? Common things that you’ve seen repeated over the years?
Lynton (32:51 – 34:09)
Well, I think one of the things, making sure that you have good books and records and that there’s not… So when you come to presenting the company for sale, you don’t have to make a lot of adjustments and try and convince a buyer that what he’s buying is very different to what’s being reported in the financial statements and tax returns year after year, because that just makes people more sceptical and look at those cash flows as being more risky. So that’s where you’re going to get earnouts and things like that, as opposed to a clean set of financial statements, you probably with less normalization adjustments.
So there’s more certainty with respect to those financials would generate, should generate a higher multiple and a higher value for the company. Having the management team in place, making sure that there’s employment agreements with all the employees, non-compete agreements. So those types of things definitely make the company less risky.
Customer contracts, is there recurring revenue? But I think the management team quality of financial information is important as well.
Armando (34:11 – 34:25)
So interesting, you began talking about the balance sheet. If the company were sold for assets, which kind of sets the low end or maybe the very low end of the range of values.
Lynton (34:26 – 35:08)
And we look at that, that’s the floor. So we said the value really shouldn’t be significantly less than what the asset value is. Now, if there are a lot of receivables on that balance sheet that are aged way, way past due, they’ve never been written off.
You obviously would have to go through a process of adjusting those assets down to what the realizable value is. So looking at receivables and making sure that everything’s collectible, that all the inventory is saleable, but assuming that the assets on the balance sheet are relatively close to realizable value, then yes, the balance sheet should be the floor to that.
Armando (35:08 – 35:27)
Yeah. And you mentioned that intangible assets, they’re not there. And I had a conversation with an intellectual property attorney recently, who her whole role is helping to protect a company’s intellectual property.
And you said that that can be- And that’s a good point.
Lynton (35:28 – 37:02)
That’s definitely something. So if someone’s going to come in, remember, a sophisticated buyer is going to do due diligence. So they’re going to want to make sure that the IP is protected.
And to the extent that there’s IP that’s not protected, that makes the company more risky, and that’s going to lower the value. But if you’ve gone through a process of protecting the IP and making sure that, from a legal standpoint, it’s going to be hard for someone to copy the company’s assets and the trade secrets are all protected and the employees have employment agreements where they can’t just leave and take all these assets with them, as part of the due diligence, they’re going to look at those things, sophisticated buyer, and would probably pay much less for a company that hasn’t done a good job of contractually tying up, making sure that all employees have valid non-competes and employment agreements, and that the IP is well protected. All of those things are going to help with value.
Even when you get an offer, a letter of intent, it’s always a non-binding letter of intent, and it’s subject to the buyer doing due diligence. And that due diligence process is fairly onerous, and they’re going to go through the process of looking at all of those legal aspects to make sure that what they’re buying is well protected.
Armando (37:03 – 37:41)
Yeah, that makes sense. That makes sense. So, the business valuation that you’re doing, looking at a range of values or establishing a range of values, you mentioned that the founder who is being more proactive can do that ahead of time to learn a lot from the process to help him or her increase the value and maybe position it for a future sale.
I wonder if the business owner is thinking of bringing in or maybe making some of the employees partners, and they’re going to maybe buy in, that would be another reason why they might want to have a valuation as well.
Lynton (37:41 – 38:29)
Yeah, absolutely. If they want to do some kind of valuation, where they’re gifting or selling stock in the company to family members, to the next generation of owners and operators of the business, you would need to have a valuation done from a tax perspective, which would ultimately be attached to a gift tax return or would be the basis for a sale of the company, just to make sure that it’s an arm’s length. Even if you’re selling it, you need to establish that that sale is on an arm’s length basis, because otherwise it’s going to be attacked by the IRS, and it’s not going to meet that objective of either a gift or a sale, both of which would require a valuation to establish the arm’s length nature of the transaction.
Armando (38:30 – 38:37)
Right, right. Otherwise, the IRS could disallow what’s being reported on that return. Correct.
Lynton (38:37 – 38:51)
If there’s not a qualified appraisal, if there’s no real basis that establishes the fair market value of the company, and it gets challenged by the IRS, they’re going to disallow the amounts of the transaction.
Armando (38:51 – 39:30)
Yeah. So then the work that you do is also used in estate planning, in terms of if the family doing the estate planning owns a business worth significant value, then with the gifting, with the estate taxes and all that, having a value on that business can be very critical in good estate planning. But I also would like you to touch on, if you could, the discounts that may be there for businesses that cannot readily be sold, that are going to be transitioned to the family or to a family entity.
Lynton (39:32 – 42:57)
Absolutely. This is from a tax standpoint. If you’re gifting an interest in the company that’s a non-controlling interest, let’s say it’s a 49% interest in the company, where a 49% shareholder doesn’t have the ability to control corporate actions, can’t make distributions, can’t effectuate a sale of the company, you’re going to apply a discount for what we call lack of control.
So fair market value looks at, well, what would a hypothetical buyer pay for that 49% interest? And if that 49% interest isn’t giving you any of what we call the prerogatives of control, you’re going to pay less than you would for a controlling interest. It’s just there’s actual studies that determine that where you don’t have control, you’re going to pay less than the prorated value of a controlling interest.
So from a tax perspective, when you do gifting, you’re going to typically gift minority interests because that’s going to allow you to take two discounts. One we’ve just touched on, the discount for lack of control. And then the second one is what we call a discount for lack of marketability.
It’s a discount because a minority interest in a privately held company is just essentially a stock certificate. You can’t really do anything with that stock certificate. You can’t call your broker and you can’t, and oftentimes tied up by a shareholder agreement that doesn’t allow you to sell that interest to anyone outside of the family, or there’s rights of first refusal and a lot of other mechanisms that are put in place.
So you don’t have the ability to go and turn that stock certificate into cash. So that requires what we call a discount for lack of marketability. But when you’re valuing that interest for tax purposes, you’ll apply discounts that both reflect the lack of control and reflect the lack of marketability, which gives the controlling shareholder the ability to sell gift minority interest in his company at a discounted value.
And that saves him in future estate taxes. Because often you can give multiple minority interests that essentially get valued from the perspective of that specific interest. You don’t apply what we call attribution.
You don’t aggregate those individual transactions. You look at what would someone pay for that specific interest. So you could essentially gift a series of minority interests at discounted value so that all that’s ultimately left in the owner’s estate is a minority interest, which is also going to be discounted.
So you have the ability with effective estate planning to really reduce the value of that company for estate tax purposes by embarking on an efficient gift and sales strategy over a period of time that’s ultimately going to lower that estate tax obligation that would be due when the founder eventually passes Right.
Armando (42:57 – 43:33)
Right. Yeah. And that can be substantial.
And the estate tax thresholds are supposed to drop if nothing changes, they will drop already legislated to do so. But the way they are for somebody who is trying to take advantage of those current estate tax thresholds, which is pretty high, then they might want to they might want to think about that, talk about what that their tax CPA and their estate planning attorney, and then maybe engage if they have a business, engage someone like you to help ascertain a value for that planning.
Lynton (43:33 – 44:19)
Our valuations will get attached to that gift tax return. And the IRS, there’s a three year statute of limitation period. So after three years, the IRS can’t go back and challenge the value that was placed on the company in that on that gift tax return.
And you can really have an it’s a very effective strategy to gift interests in a company over time, especially if the next generation is going to be involved in managing the company going forward. So you can essentially transition ownership at discounted values, and then reduce the overall value of what’s left in the estate when the owner eventually passes away.
Armando (44:20 – 44:39)
Yeah. Okay. So another good reason to, to engage, you know, you with your expertise when if that’s part of what the thought process is for that founder, and that family, then it makes sense for them to have a conversation with you and go through that process, along with their probably their tax CPA, maybe their estate planning attorney as well.
Lynton (44:39 – 44:55)
Yeah, and absolutely. We see that all the time. We do a lot of valuations for both gift tax purposes and estate tax purposes.
So and those valuations have to be attached to the gift tax and the estate tax returns.
Armando (44:56 – 45:02)
Okay. Okay. Yep.
So with that, with that threshold dropping, is it 2026?
Lynton (45:02 – 45:14)
I think it is when the Yeah, I think it’s the sun sets out unless anything happens. I think 2026 is when that effectively will, will drop down to two prior levels.
Armando (45:14 – 45:37)
Right, right. So that could be pretty darn significant. So are there any any changes in your industry, Lynton, that you’re seeing that, that would impact the value or the process or anything that founder who’s not gone through the process with you or someone like you before, anything that is changing in your space, from an industry standpoint, or?
Lynton (45:38 – 47:12)
Well, I think what’s happened, and we’ve seen this significantly, probably over the last 10 years is the amount of private equity buyers that are in, that have come into the industry, and are buying up companies, privately held companies in our space. You know, 10, 15, 20 years ago, there was no private equity. So there really wasn’t that viable exit strategy.
Now we see private equity is a major buyer of companies in, in different industries, sometimes as part of a roll up strategy. We see, you know, private equity buying up multiple companies in a specific industry, and rolling them up into something, you know, larger to ultimately sell to someone else, who otherwise maybe could take public, you know, over time. So there, there are a lot more buyers in in the market now, than they’ve been historically, you know, right now, because interest rates are trending up.
And private equity, typically, these transactions, most of them are highly leveraged. So the private equity is putting in, you know, some equity, but a debt, as interest rates go up, it makes the debt piece of the transaction more expensive. So that has a dampening impact on value.
But there are certain industries that are still, you know, rapidly consolidating and private equity, still very active in certain industries.
Armando (47:16 – 48:05)
Okay. So we talked about the discounted values. I am curious.
So then when a, when a founder is thinking that he or she will sell, you know, they begin realizing that they’ve got plenty of, there’s plenty of money there already, they still have a significant chunk in that business. They’ve got to look at what that next step is for them in their lives personally. And then how do they, how do they transition that company to the new ownership?
And they’re maybe evaluating different methods they can do to exit that business. So I guess in that thought process, when would it be ideal for them to have a conversation with you? When in that process would make most sense to talk with you?
Lynton (48:05 – 50:40)
Well, as I said, the more proactive you are and the longer the runway is, the more time you have to, you know, put everything in place so you can maximize value. So a lot of times I guess we get called when there’s that unsolicited offer and then we’re reacting. So rather be more proactive and look at a strategy and a timeframe where we think in the 12 to 18 months we want to sell the company.
So it gives you more time to essentially engage in a more competitive sale process, better understand value, you know, do things that you’re going to be able to do to increase value as opposed to reacting to an offer where you theoretically or practically have limited time to address that offer and makes things more stressful. So the more proactive you are, the more you’re going to be able to facilitate a more orderly sale of the company. But the reality is it doesn’t always happen like that because often, you know, the buyer or the founder, you know, isn’t even thinking of sale.
And then someone, you know, calls him and says, you know, we really want to buy your company and, you know, makes them an offer that sometimes they can’t refuse. And in those situations, you’re really, you know, reacting and you’re really working more to the buyer’s timeframe, which oftentimes is fairly accelerated. So you don’t get, you don’t have the luxury of time.
And sometimes that’s just the practical reality because some of these calls do, as they say, come out of the blue. You know, you’re not expecting it. And all of a sudden, you know, you get that call and now you’re trying to figure out, well, how do I establish value?
And I’ve got to set up a data room. They’re asking for all this information. I don’t really have it.
So the more proactive you are, the better able you are to at least get everything set up to make that process more efficient. It is a process and it can be fairly onerous. The requirements and the data that gets requested as part of the due diligence is voluminous.
But you have to be prepared to go through, you know, a fairly painful process, but the end goal is you’re going to get a check and hopefully you’re going to get the full value of what you spent your life building up and then you can move on to the next phase of life.
Armando (50:40 – 52:00)
Yep. So I spoke with a retired CEO who had acquired a lot of companies along the way as roll-ups into the mothership company that they had. And he told me that when he was buying companies, he really liked talking with the small mom and pop shops, the small companies that had never sold before because they didn’t know anything.
And in his role as the CEO of this company, that was when he could do best by his stakeholders, his shareholders, his board, his constituents, because he could get the best price because the sellers of those other companies had never gone through a sale before. They didn’t know what they didn’t know. So he could make them an offer and pretty much draft the terms that he wanted in that sale.
And it worked out better for the buyer, but it totally did not work to the advantage of the seller because seller didn’t engage people along the way who could have helped them maybe understand that maybe value is too low or maybe value is right. But as you said, the terms are the part of that equation. Maybe the terms of the sale are not in the best interest of the seller.
Lynton (52:01 – 53:19)
Yeah. And often, in the example that you just mentioned, someone’s got an unsolicited offer for $30 or $35 million and they call us and we tell them what’s going to cost you $15,000 or $20,000 to do a valuation. And they really don’t want to spend the $15,000 or $20,000.
And it’s a $35 million transaction. And I’m always thinking, well, wouldn’t you want to, this is just your due diligence, you need to spend some money just to at least satisfy yourself that what you’re getting is a reasonable offer for the company. And relative to that transaction price, it’s really not a lot of, it’s not a huge investment.
And it’s unfortunate that you’re going to have to spend money to make that determination. But just for peace of mind, you want to make sure that you’ve at least gone through some due diligence. You don’t want to open the paper a week later and see that your competitor, who’s smaller than you are and maybe less profitable, sold to the same buyer at a significant premium to what you were paying.
Because that buyer did more due diligence and pushed the envelope a little more and was able to attract a higher purchase price.
Armando (53:19 – 53:36)
Right. And if this is truly a once in a lifetime sale, and this is your biggest asset that you will ever have in your life, it seems like a very small investment, $15,000 to $20,000 to make sure you’re getting the value you should be getting for what you spent years building.
Lynton (53:37 – 54:56)
And also, you need to have an attorney. That’s what I tell people as well. One of the first things I ask is, who’s your attorney?
Who are you working with? Who’s your CPA? Because you need to have a team.
We can cover the valuation aspect, but I can’t cover what’s the most tax-effective strategy. Are you going to do an asset sale or a stock sale? Having a CPA to make sure that you’re not signing on to very onerous reps and warranties and that you have some protection.
Once you’re in that transaction process, you need to make sure that you have a team. I see the valuation aspect as one component of the team, but it’s legal, accounting, valuation. There are a lot of different professionals that need to be engaged in this process to help make sure that the buyer is extracting maximum value.
As I said, the value is one piece of it. It’s the structure is as important, sometimes more important than what the value is, because you can structure it in a way that’s ultimately going to give you more money in your pocket by adopting sometimes simple tax strategies that help maximize value.
Armando (54:58 – 55:39)
I’m glad you brought that up because I’ve heard business owners before tell me they’ve got a great lawyer who does all this stuff for them, but the lawyer doesn’t really spend a lot of time in the M&A space, the merger and acquisition space, the buying and selling of companies. Not to discredit the attorney, because I’m sure he or she, what they do are very good at it, but if you just don’t work in that merger and acquisition space enough to get the experience and the know-how, then how can you possibly do the best job for the client, for the seller, the owner of that business when he’s going through that once-in-a-lifetime transaction?
Lynton (55:40 – 56:16)
It is, as you said, specialized, so you do need to make sure that you have an attorney that specializes in mergers and acquisitions and purchase contracts and can definitely help you. I get involved in a fair amount of purchase price disputes where, post-transaction, we get hired as an expert in a purchase price dispute where the issues that have come up post-sale that could have been avoided had everything been properly documented during the transaction.
Armando (56:17 – 57:14)
So, Lytton, people, if they’re being proactive, thinking down the road that they should come see you to help get an understanding of the value of their business, but as you said, they will learn in that process things that they can do to increase that value and make them more sellable later. So, that’s one reason why they might want to come to you. You also said that they get an unsolicited offer at times and they’ve accepted it or they want to accept it and you get pulled in when that is already in play.
So, you’re doing your work as part of that sale. You mentioned also estate planning when a business owner is thinking of transitioning the business maybe to the next generation and getting the valuation to establish that value for the gift tax returns and that for the IRS. Are there other situations or I guess I should say, what other situations are there when you get engaged in the process to do your work?
Lynton (57:15 – 58:30)
Well, one of those is ESOPs or employee share ownership plans and that can also be an effective way of transitioning the company to current employees and in an ESOP transaction, it involves an initial value of the company to establish the price that the ESOP pays the owner and then on an annual basis, you have to do a valuation to assist with any people that are part of the ESOP that are selling their interests that would be subject to valuation. So, that’s another example of where we and I’m working actually on two ESOP transactions right now where that’s how the company is transitioning the ownership of the company through the establishment of an ESOP plan and the valuation is one part of that ESOP plan.
So, we are involved in both of them, I guess, initial feasibility to make sure that A, the value makes sense and that the company’s cash flow and support an ESOP transaction and that ongoing commitment to repurchase shares from the ESOP.
Armando (58:32 – 58:51)
Okay. And so, Lynton, anything that we haven’t talked about in this conversation, maybe in those conversations you have with the founder who’s never had a conversation with someone like you, this is the first time they’re going through this process, they’re learning, of course, as they go through the process, things that we haven’t talked about that you often talk with those owners about?
Lynton (58:52 – 1:00:30)
I really think we’ve had a fairly comprehensive and detailed discussion. We’ve touched on a lot of the important aspects of a sale and how when valuation becomes an important component, so it’s the sale of a company, it’s tax planning, and also sometimes people just want to understand for future reference, what is my company worth? And then what do I need to do to help increase value?
Because often they’ve had this company for multiple years and they’ve never really gone through a formal valuation process and this is the most significant asset in their portfolio and they have no idea what the real value of the company is. Even if they’re not anticipating a current offer, we get retained and I’ll be honest, it’s not often but we have been engaged in numerous occasions where someone just wants to understand and get educated on what’s the value of my company. Every year I have to fill out a personal financial statement and one of the lines on there is what’s the value of the company and I really never know how to answer that question.
So, it’s an educational exercise where we go through the process and I said it’s very interactive. It’s not a black box. We try and educate and walk people through so they can get an understanding of how value is determined and what’s the process we go through to determine that.
Armando (1:00:32 – 1:00:41)
Okay. Now, that makes sense. I can see, as you described that, I might want to buy sale agreements when you have a partner or partners.
Lynton (1:00:41 – 1:03:05)
Okay. That’s also another really important point that you bring up. We often will get hired by attorneys to assist them in drafting and structuring a buy-sell agreement and the valuation clause that goes into a buy-sell agreement.
Often, we’re getting hired in a litigation where the buy-sell agreement was they started drafting and it was never signed or it had reference to a certificate of agreed value that was never obtained and now the partners are going through a dispute and it becomes fairly expensive. Whereas, if they had executed a proper buy-sell agreement when they first went into business and had followed the process that was outlined in the buy-sell agreement, it would be much easier for the parties to separate. So, that’s really important, especially where you have multiple owners of a company is to make sure that there is a valid buy-sell agreement between the owners that has an ironclad valuation clause or provision that details exactly how that process will work when someone wants to exit the company and avoids a protracted litigation.
So, that’s a really good point and another area that owners of companies, especially if there’s multiple owners, that you should always make sure that they do have a valid buy-sell agreement. Because I can’t tell you how often I’ve seen buy-sells that were never executed or even buy-sells that were executed, but the buy-sell had an agreed-upon value and calls for an annual agreed-upon value that goes into the buy-sell. It hasn’t been updated for multiple years.
So, the buy-sell really doesn’t have much weight because the primary component is that agreed-upon value and it hasn’t been updated. Very important to have a buy-sell agreement and make sure that it has a valuation clause and whatever the provisions of that clause are, it’s being updated and properly followed.
[Speaker 3] (1:03:05 – 1:03:06)
Okay.
Lynton (1:03:07 – 1:03:44)
Even I’ve seen clauses where they’ll agree to who’s going to do the appraisal or how the process is going to work with some kind of multiple or some formula that they agreed to when the agreement is signed, and that can effectively transition the sale in that scenario. Because otherwise, you can get into situations of deadlock and lockouts and it can really be a huge disruption and reduce the value of the company. So, that buy-sell is another important component where valuation is critical.
Armando (1:03:45 – 1:03:47)
Okay, good. Good. I’m glad we talked about that.
Lynton (1:03:47 – 1:03:50)
It needs to be addressed. So, yeah, that’s a really good point.
Armando (1:03:50 – 1:04:15)
Okay, good. Let me just summarize a little bit here. You mentioned different ways to get evaluations.
I’ve been scribbling notes as we’ve been talking here. You mentioned a top-down approach. Looking at the industry, the big picture, what is the industry, what’s happening in the world that impacts your industry?
And then looking at really drilling down the floor or you want to sell above the floor, you said the asset approach?
Lynton (1:04:15 – 1:04:28)
Yeah, you want to get some consideration for intangible assets that have been developed over time. And those intangible assets, because they’re internally developed, you’re not going to see them on the balance sheet.
[Speaker 3] (1:04:28 – 1:04:29)
Right, right.
Lynton (1:04:29 – 1:04:45)
If you look at a balance sheet, in most cases, if you make an acquisition, then you’re required to record the intangible assets. But if those intangibles have been internally generated, you’re not going to see them on the balance sheet.
Armando (1:04:45 – 1:04:58)
Yeah, right. So, you mentioned an asset approach, a market approach, a guideline company method, income approach, different ways that you said you kind of get a range of values. Let’s try that.
Lynton (1:04:58 – 1:06:21)
Under each of the approaches, you have the asset approach and then you have the market approach. Under the market approach, there’s a guideline transaction method and a guideline company method and the historical transactions involving the subject company. Those methods are what falls under the market approach.
And then you have an income approach, which is looking at cash flows, how risky are those cash flows, and what’s the growth of those cash flows. And under the income approach, you would do either apply, there’s different methods that you apply under the income approach as well. But you have to consider each of those three approaches and then come up with a value under each approach and then decide which of those values, which approach is the most relevant, and then put the weighting on the approach that’s the most relevant.
And sometimes all of those approaches triangulate back to within a really narrow range, but sometimes you have very disparate indications from each of the different approaches. So, you’re not just going to average each of the approaches and come up with an average. You have to select and choose or put weighting on the approaches that are the most reasonable and then provide justification for why you’re applying the different weighting.
Armando (1:06:22 – 1:06:29)
Okay. And then, Lynton, when someone engages you to do your work, how long does that timeframe typically take?
Lynton (1:06:30 – 1:06:35)
Well, it’s honestly anywhere from 30 to 60 days is the typical time.
Armando (1:06:36 – 1:06:36)
Okay.
Lynton (1:06:37 – 1:06:41)
To do stuff properly is going to take anywhere from 30 to 60 days.
Armando (1:06:41 – 1:06:56)
Okay. Okay. And you mentioned a lot.
I can’t summarize all of it because you mentioned a lot, but I did make a couple of notes here. You said that a strategic buyer is typically going to pay more. They’re going to pay a premium over what a financial buyer will do.
Lynton (1:06:57 – 1:07:33)
Strategic premium, because there’s someone that’s already in the industry, has some strategic reason that they buy the company. So, they will typically pay a premium because they’re going to be able to absorb a lot of the company’s overhead structure to their existing overhead. So, they really can get rid of large portions of the overhead.
They may have better access or lower borrowing. They’d be able to finance this company much cheaper than how the company is currently financed.
[Speaker 3] (1:07:33 – 1:07:33)
Okay.
Lynton (1:07:33 – 1:08:29)
They would be willing to pay some kind of premium over what a financial buyer will pay. And a financial buyer is going to pay based on the company’s existing cash flow. A strategic buyer, the cash flows are going to look different to how they currently look because they have ability to do certain things because they’re strategic.
They may be able to sell the product to their customers at a higher price point. So, there’s things that they can do that’s strategic and it’s going to increase the cash flows of the company. Theoretically, they shouldn’t pay for any of those synergies that they’re bringing to the transaction.
But in the real world, they often pay for those synergies. And sometimes those synergies aren’t realized. And that’s how you end up overpaying for it.
Okay. Anticipating synergies that aren’t realized.
Armando (1:08:30 – 1:08:53)
Okay, good. Well, this has been a very good conversation. We’ve touched on a lot.
You also mentioned that for estate planning purposes, gift tax returns, maybe a buy-sell with partners, but lots of reasons why a business valuation can make sense. And if someone is interested in exploring how this might work for them, what they can do with the business valuation, how should they try to reach you?
Lynton (1:08:54 – 1:09:23)
I’m sure you have my contact information. They can call me. We can set up an initial consultation.
I’m happy to talk to them about the process and why they would need a valuation. We try to condense something that’s pretty complex into… We’ve been talking for just over an hour and I think we’ve done a good job.
We’ve covered a lot of the highlights, but this is something that we literally could have probably spent three hours talking.
Armando (1:09:23 – 1:09:50)
Right. Right. Okay, good.
And you said typically $15,000, $20,000 to cost, $30,000 to $60,000 to get it done. But if this is in fact the biggest asset that the person has, and this is their once in a lifetime sale to transition out of that business, it might make sense for them to spend a little money, get that range of values and understand what’s driving value in their company before they sell.
Lynton (1:09:50 – 1:10:03)
Look, and those costs are ranges. Obviously, depending on how complex the company is, how messy the underlying financials are, those are all factors that would potentially increase costs.
Armando (1:10:03 – 1:10:06)
Yeah. And sometimes financials can be pretty messy.
Lynton (1:10:07 – 1:10:13)
Private deal companies that aren’t getting audited, those financials can be really messy.
[Speaker 3] (1:10:13 – 1:10:14)
Yeah.
Lynton (1:10:14 – 1:11:02)
So you want to at least recast the financials to reflect the true economic earnings of the company. So sometimes that involves a lot of adjustment and what we call normalization to recast the financials to get them to a point where you can use it as a foundation to establish value. Remember, it’s garbage in, garbage out.
So you want to make sure that you’re normalizing and making adjustments so that it’s not garbage in, garbage out. You’re coming up with a reasonable and realistic estimate of what future cash flows are because that’s really what’s going to drive value. So the more accurate and the more reliable that indication is, obviously, the more accurate and reliable the ultimate value indication is.
Armando (1:11:03 – 1:11:10)
Okay. Good. Good.
And is there a preferred number that you’d like people to call you at or would you rather they email you or go to your website?
Lynton (1:11:10 – 1:11:22)
Yeah. Email’s good. And you have my email information.
Otherwise, my office number 602-544-3552 is always a good number to reach me on.
[Speaker 3] (1:11:23 – 1:11:23)
Okay.
Lynton (1:11:23 – 1:11:29)
My email is lkotzin, K-O-T-Z-I-N at jsheld.com.
Armando (1:11:30 – 1:11:57)
Perfect. Great. That sounds great.
Well, Lynton, thank you so much for the conversation. Really appreciate it. Hoping that the founder out there who’s thinking about that next stage for him and his family or her and her family understands that you can be helpful in that process.
They might want to have a conversation with you. And if they do, we’ll make sure to put your phone number and your email address in the notes underneath this so that people can reach out to you more easily.
Lynton (1:11:58 – 1:11:59)
All right. I appreciate it. Thank you.
Armando (1:11:59 – 1:12:38)
Great. Lynton, enjoy the conversation. Thank you so much.
Hope you enjoyed this episode of the Founder’s Guide Post. Whether exit is on your immediate horizon or maybe 10 years down the road, there’s something here for you. And remember, we all have an expiration date.
We just don’t know when that will be, which is why planning ahead is critical. And if you’re wondering if you’ve missed anything in your planning, contact me to schedule your founder’s strategy call. You may call our office at 480-367-9000 or schedule a call at axiomcorp.com.
Here’s to your American success story.
Leave a Reply