In this blog I would like to entertain a high-level discussion of valuing a business by employing the Discounted Cash Flow methodology. Creating a discounted cash flow model does require some basic understanding of the principle of “time value of money,” discount rate and some skill in Excel. The intention of this blog is not to teach these principles in detail, rather to serve merely as an “eye-opener” and encourage small business owners to think more critically about valuing their business.

Discounted Cash Flow analysis consists of two steps. The first is to determine future cash flows for the business or entity being valued. In determining future cash flows there are a few things that should be taken into consideration.

1. What is cash flow? The definition of cash flow, sometime called “free cash flow” can vary slightly depending on the desired approach. However, cash flow is typically defined as cash flow after removing all expenses necessary to run and grow a business over time. Mathematically cash flow can be calculated by taking cash flows after all operating expenses less taxes less necessary investments in working capital and property plant and equipment plus all non-cash expenses (i.e. depreciation).

2. How many years of cash flow should I use in my analysis? Typically the further out you forecast cash flows the less accurate they become. This is where your judgment and expertise in your industry will come into play. If you feel strongly that you understand the industry and that the industry is relatively stable, you may be able to project further into the future. Although somewhat arbitrary, most practitioners limit cash flow projections to 5 years.
As with all analysis, the old adage “Garbage in, Garbage out” holds true with Discounted Cash Flow analysis. The validity of your analysis depends on your ability to make solid cash flow projections. Doing so will require you to understand the drivers of your business as well as industry dynamics.

The second step in the Discounted Cash Flow methodology is to determine a discount rate. A discount rate represents the rate of return you require on an investment and it is the rate at which you will discount future cash flows. It is derived by understanding two things: what is my cost of capital and what is the appropriate risk premium for this organization. Both cost of capital and risk premium will be unique to each individual organization.

1. Cost of capital is a function of the sources of capital an organization chooses to use in order to finance its operations. For example if an organization funds all of its capital expenditures by taking out debt, the cost of capital would simply be the cost of interest paid on that debt. If however, an organization uses equity, the cost of capital on the equity would be the “opportunity cost” of investing the capital in another opportunity. Typically your cost of capital can be calculated by taking a weighted average of the cost of debt and equity financing.

2. Risk premium is much less lucid than cost of capital and will vary greatly with the perspective of the investor or entity valuing your business. For example you may assign a lower risk premium to your business because you understand the industry in which you compete and have existing expertise. However, for a potential acquirer lacking similar expertise, your business may pose more risk, thus requiring the use of a higher risk premium.

After determining cost of capital and risk premium, the sum of the two will comprise your discount rate. Per the principles of “time value of money,” the higher the discount rate used to discount cash flows, the less those cash flows will be worth. So a higher risk premium will lower the value of your business.

The intricacies and nuances of developing a sound Discounted Cash Flow analysis clearly can not be captured in one short blog. However, there are various resources including templates available online that will walk you through, in more detail, the steps of developing a solid analysis. Your effort to value your business before you sell it will empower you when it comes time to negotiate a selling price.

Richard Zollinger is a finance manager at American Express.

In every small businessman’s career there comes a time when thoughts must be turned to an exit strategy. That is, what is the end game? How will you cash out? Will you cash out? Will you leave your business as an inheritance to children or other family members? Whatever the plan or strategy for moving out of your business, it is critical that you have an understanding of what your business is worth.

There are a number of different methods for valuing a business. This blog represents the first of three blogs intended to entertain a high-level discussion of three commonly used valuation methodologies: Cost, Discounted Cash Flow and Price/Characteristics Ratios. The Cost Methodology will be discussed first.

The cost method of valuation involves two steps. First the business owner or hired consultant must assess the cost to replicate existing assets.
There are four ways to determine the replacement value of existing assets. The method chosen depends on the nature of the assets and the reason for the valuation.

1. Book – The book method is relatively straight forward and would be accomplished by taking the value of assets from the balance sheet less accumulated depreciation. Any good accountant should be able to help with this relatively simple approach. The book value method would be most effective if the business was recently purchased, thus the assets would theoretically reflect current market values.
2. Adjust Asset – The adjusted asset method requires analysis of each asset on the balance sheet and would be helpful if book values are significantly different than market values. With this approach the consultant would take the book value of say a piece of land. He would then assess the market value of the land and adjust the book value to reflect current market values. This approach can be very time consuming.
3. Liquidation – Similar to the adjusted asset method, the liquidation method seeks to understand the value of each asset. However, with the liquidation method the consultant is not concerned with market value rather contingent, contingent on bankruptcy, value. This approach may be most likely used by a banker to determine what the value of a business’ assets would be if the business were to go bankrupt. Value determined by this approach will clearly be less than adjusted value.
4. Replacement – This method of determining replication cost seeks to ascertain the required cost to replace existing assets using current technology. For example if a high-tech manufacturer has an existing plant that it built 5 years ago for $1.0M but, with technological advances could build the same plant for $0.8M, the building would be valued at $0.8M. This approach of determining replication value would be best used in industries where technology has dramatically changed the cost to replace assets.

The second and final step of the Cost method is to assess the value of a company’s intangibles. Intangibles might include brand recognition, favorable relationships with clients or customers, experience and knowledge. Not all intangibles are positive. For example a pending lawsuit would be a negative intangible. After all intangible values are assessed they can be added or subtracted from total replication cost to determine the Cost of the business.

Due to the subjectivity and difficulty of determining the value of intangibles and at times the inability of accurately determining the value of fixed assets, the cost approach should be used with some hesitation. But at the same time can serve as a good exercise to understand the true value of company assets.

Richard Zollinger is a finance manager at American Express.

The importance of cash flow and liquidity to the success and survival of a small business is not a lesson that successful small businessmen need. They already know of its importance. What small businessmen might need however, is a toolbox of cash flow management tools. To this end I have shared a few thoughts on factoring and vendor credit as such tools. Another tool that is available to businesses of all sizes is the PEO.

Professional Employer Organizations provide many valuable services, most of which are easily recognized and well touted. However, there is a likely unknown positive side-effect of using a PEO, cash flow management.

For many small businesses, employee taxes are payable on either a monthly or quarterly basis. These tax bills are not small and leave many small businesses scrambling at the end of the month or quarter to come up with the cash to pay the government. However, when using a PEO, the PEO is responsible for paying the monthly or quarterly tax bill. As a result the PEO collects those taxes from the employer or small business as part of the regular payroll invoicing cycle. In this case the PEO acts as a type of savings mechanism. Although the small business will be forgoing the use of the funds the PEO collects a few weeks or months in advance, there will be no month or quarter end scrambling to pay the bill.

In most states businesses are required to pay a quarter of their worker’s compensation premium at the beginning of the year. The rest of the premium is then paid on a regular basis throughout the year. For many small businesses this initial payment of their worker’s compensation premium can be rather substantial. Not only can it be difficult to come up with the required sum at one time, but the small business forgoes the use of the funds used to pay the premium several months before the benefits of the insurance are consumed. PEOs help to smooth out cash flow by collecting the worker’s compensation premium as part of the regular payroll invoicing cycle. There can be no upfront payment required of the small business. This means your cash can be working for you in the bank or helping you to grow your inventory or extend vendor credit as you work to grow your business.

The PEO serves as a mechanism to smooth out cash flow. In neither of the above cases would you avoid payment of expenses. However, the PEO does help you manage the cash flow associated with the payment of these expenses and therefore represents another tool that can be used in your overall cash flow management strategy. Although it is unlikely that you would make your decision to use a PEO based solely on the cash flow management that they provide, it is a benefit that should be considered.

Richard Zollinger is a finance manager at American Express.

For companies of all sizes, cash is the life-blood for survival. This is particularly true for start-up and entrepreneurial ventures. There are many tools available to help manage cash flow. One of these tools that has recently gained wide acceptance is Factoring.

Factoring is simply the selling of accounts receivable to a finance company known as a “Factor”, at a discount. For example, “XYZ Corp.” may decide that it has a need for quick cash flow. At the same time “XYZ Corp.” may have a particular account with receivables of $1,000. “XYZ Corp.” would find a “Factor” and sell to that Factor the $1,000 receivable. At the time of sell “XYZ Corp.” would receive 70-90% of the $1,000, with the remaining 10-30% minus a fee payable at the time of collection.

Factoring has recently become very competitive, resulting in wider acceptance as well as a reduction in fees. Before deciding if factoring is right for a given company, one should understand the basic elements of factoring, weigh the pros and cons of factoring, and ensure that factoring fits the particular business’ operational characteristics.

Factoring – Elements

• A quick and easy way to generate cash flow. In most cases cash can be received within 24 hours
• Factors charge a transaction fee and take a discount of between 2-10% depending on factor period and size
• Factors generally pay 70-90% up front and the remaining 10-30% minus a discount upon full collection
• Factors’ decision to purchase the receivable is based on strength of the customers’ financial strength and not that of the seller of the receivable
• Factoring is flexible – companies can chose which receivables to sell, when to sell them and for how long they will sell them

Factoring – Pros and Cons
Pros

• Quick and easy method for obtaining cash
  
• Allows a growing company to take advantage of a big sales opportunity that poor cash flow would normally prevent
  
• Allows a company to take advantage of vendor discounts by paying invoices early
  
• Allows a company to extend vendor credit to a large and or important client
  
• Improves immediate cash flow situation
  
• Factors assume risk of non-collection associated with receivables
  

Cons

• If used as a permanent means of financing factoring can be much more expensive than conventional sources of cash
• Customers may not like paying and dealing with a third party – i.e. Factors

The beneficial application of factoring has a lot to do with the operational characteristics of a business. For example a company with very small margins would generally be ill-advised to use factoring, as fees would eat up profitability quickly. For companies with large amounts of cash on hand, factoring does not make sense either. If however, a company’s margins are large and cash in-flow is variable while expenses are steady, factoring might be beneficial for smoothing out the low cash flow periods.

Factoring, like vendor credit is simply another cash flow tool. It can best be used by shopping around for and setting up a relationship with a Factor before cash flow becomes an issue.

Factoring should be used sparingly to take advantage or large opportunities or smooth out short-term cash-flow lows. The internet is a great place to learn more about factoring and to search for a Factor that fits your business needs.

Richard Zollinger is a finance manager at American Express.

I recently read an article about eSys, a technology hardware manufacturing company. Founded in 2000, eSys saw revenues grow from $0 to $2 billion in 5 years. eSys had 112 offices in 33 countries, had acquired and turned around 12 money-losing businesses and had an astonishing $0 in long-term debt. So how do you grow a business, almost over night, from $0 to $2 billion in sales, without taking on any long-term debt? In eSys’ case one of the keys was vendor credit.

Vendor credit can be defined as buying something now and paying for it later or in installments. Unlike a bank line of credit or long-term debt, vendor credit is free or almost free. There generally is a cost associated with vendor credit, although it is implicit rather than explicit. By taking advantage of vendor credit you will likely forfeit any up-front discounts associated with paying a vendor early, usually 1 to 2 percent of the purchase price. However, if you want to lengthen your average payment cycle thus increasing your cash flow and growing your business, this implicit cost is well worth the price.

If you produce ice cream, you may ask the dairy that provides you with cream to extend your payment period. For example rather than paying for the cream within 30 days of invoice, you may ask the dairy to allow you to pay for the cream in 60 days. This is an example of taking advantage of vendor credit to lengthen your average payment cycle, to increase your cash flow and to grow your business.

So how do you go about convincing your vendors to extend you vendor credit? I have a few ideas:

-You have to ask! It is possible that if your vendors are not doing business in a competitive environment, that they will not come forward with the suggestion that you take advantage of credit they may be willing to extend. If this is the case, you will have to ask them to extend vendor credit to you.

-If you are a newly established business, you may need to convince your suppliers that you are credit worthy. That’s right, just like you have to sell your products or services to your customers, you may have to sell your business plan to suppliers. Take seriously the opportunity to sell your plan, be prepared to answer tough questions and show sincerity in your desire to be successful. If you are an established customer and have been loyal to your supplier, this sell should be much easier.

-Along with selling your business plan, help your suppliers to understand your potential success. Make a special effort to draw a connection between your success and theirs. You should also emphasis your interest in remaining a loyal customer for the long-haul. It is likely that a supplier will weigh the short-term risk, selling small amounts of product on credit now, versus the long-term benefit of huge sales in the future.

-Offer to personally guarantee some of the purchase price of your initial inventory purchase. Although this may be a bit scary, it may be necessary to initially convince suppliers that you are worth the risk.

-Buy insurance on whatever you owe your suppliers and name them as the beneficiaries. The cost of such insurance would be a fraction of the cost of conventional bank borrowing.

-Shop around! Visit with two or three suppliers about the potential of purchasing on credit. If your suppliers are in a competitive environment they will be more likely to sell on credit just to get or keep your business.

In summary, remember two things. First, in the business world “cash is king” - by using vendor credit you can conserve more of your own cash for growth. Second, using other people’s money, is always better than using your own.

Richard Zollinger is a finance manager at American Express.