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.

Summer is upon us and its time to load up the wife and kids and head out on vacation. If you’re anything like most of my clients, you are looking for ways to turn personal expenses into legitimate business expenses—there are many ways to accomplish this when combining personal and business travel. As always when dealing with saving taxes, planning in advance and good record keeping is key.

Mixing Business and Pleasure with Travel

Michael Bartholomew is a CPA at Jensen & Keddington, P.C. in Salt Lake City, UT. He can be reached at (801) 262-4554 or mikeb@jensenkeddington.com.

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.

When it comes to charitable contributions, giving may be better than receiving, but receiving a tax deduction now requires a little more effort, in light of new substantiation rules introduced in the summer of 2006 (but not effective until 2007 for calendar taxpayers). To ensure that you can claim the charitable deductions to which you’re entitled, we want to make you aware of these new recordkeeping rules.

Cash Contributions of Less than $250 in Single Donation. For cash contributions, it’s not unusual to give small amounts without expecting a receipt, such as when you drop a $20 bill into the collection plate at church. These amounts may accumulate to a sizeable sum by year-end. Previously, if the donations were less than $250, you could either keep cancelled checks or reliable records, such as a list that you’ve prepared showing the dates, amounts donated, and charities. Under the new rules, however, it’s no longer sufficient to simply keep good records of these donations when you tally up the amount to claim as charitable contributions. Instead, cash contributions of less than $250 given in a single contribution are only deductible if you keep a bank record (most likely a cancelled check, wire transfer acknowledgement, or credit card record) or written acknowledgement from the charity (donee) showing the name of the donee organization, the date of the contribution, and the amount of the contribution.

If you are likely to itemize deductions on your income tax return and typically make cash contributions of less than $250, you should make donations by check rather than cash, because that will easily satisfy the documentation requirements. Simply keeping good records of the donations will no longer be enough to claim the deduction.

Contributions of Used Clothing and Household Items. If you typically donate used clothing or household items to charities, such as Goodwill, the items must be in “good condition or better” unless the items were worth more than $500 and a qualified appraisal report is attached to your tax return. The IRS has not yet defined what is meant by “good condition or better.” Thus, you might consider keeping a detailed list and photos of contributed items (unless the property is appraised). No new documentation is required, but to protect yourself in case of an IRS audit, you should, at a minimum, document that the donations were in good condition. Furthermore, the use of unattended drop-off sites should be reserved for items of minimal value. It may be difficult to substantiate the contributions without a receipt.

Vehicle Contributions. If you’re planning to donate a car, boat, or plane that’s valued over $500, you have to follow strict substantiation rules in order to claim the contribution deduction. Under these rules, you must receive, and attach to your tax return, a written acknowledgment from the charity within 30 days after the donated vehicle is sold (or within 30 days of the contribution if the charity uses the vehicle significantly in its exempt purpose, makes major improvements to the vehicle, sells it for a significantly discounted price, or gives it to a needy person in furtherance of the charity’s exempt purpose). The information needed in the written acknowledgement from the charity should include the (a) name and taxpayer identification number of the donor and (b) vehicle identification number (or similar number) of the vehicle.

The IRS has just issued new rules that require donors of vehicles valued at more than $500 to attach a special form (Form 1098-C—Contributions of Motor Vehicles, Boats and Airplanes), which is received from the charity and reports the necessary information about the vehicle donation. (The form is optional for vehicle donations of $500 or less.) To claim the deduction for the vehicle valued at more than $500, you should attach Copy B to your tax return.

Property Contributions of More Than $5,000. If you’re planning to contribute property (other than of publicly traded securities) valued at more than $5,000 ($10,000 for closely held stock), please discuss these plans with us as soon as possible. Although the rules for substantiating this type of property haven’t changed, there are now stricter rules for what is considered a “qualified appraisal” and who is considered a “qualified appraiser.” You must have the appraisal done not earlier than 60 days before the donation and received by the due date (including extensions) of your tax return.

To claim the deduction, it’s important to dot all the “i’s” and cross all the “t’s” in following the requirements of a qualified appraisal. Furthermore, stiffer penalties now apply to both appraisers and taxpayers for substantial valuation misstatements.

I hope this information is helpful as you plan for your charitable contributions. It’s important to follow these recordkeeping requirements if you hope to claim the deduction for your donations because the IRS can and will disallow charitable deductions if these requirements aren’t met. If you would like more details about these or any other aspect of the new rules, please don’t hesitate to call.

Michael Bartholomew is a CPA at Jensen & Keddington, P.C. in Salt Lake City, UT. He can be reached at (801) 262-4554 or mikeb@jensenkeddington.com.