Business Management

BY BRUCE LYNCH

Why You Need To Know
What Your Business Is Worth

The recent recession has forced changes of plan for many design firm owners. For baby boomers looking to retire, the rapid and precipitous decline in individual wealth caused them to rethink their plans to transition firm ownership. Young people looking to buy the design firm they work in have been forced to put these plans on the back burner when cash became very scarce, very quickly.

Most expert observers believe that the bottom of the economic downturn has been reached (or at least we can see the bottom). Many economic indicators that impact the design industry are starting to turn positive--banks are raising money and lending again, orders for durable goods are on the rebound, home improvement companies like Lowe’s are reporting higher-than expected profits, to list a few.

This is a good time to take stock of what your business is really worth right now so you can make a smart decision about how to take advantage of the expected economic recovery. In this column, I will explain what makes the valuation process for design firms unique and what you (and your valuation expert) should consider when determining what your firm is worth.

Why general valuation techniques don’t work
There are several commonly used valuation techniques, but each has problems when applied to design firms, and you should avoid these techniques:

Comparable firm valuation. While public companies can be compared, design firms are usually closely held, and it’s difficult to obtain information about them. Comparing a private firm with a publicly held company on the basis of price/earnings ratios, as is often done, can lead to inflated theoretical valuation.

Multiple of book value. Design firms are not usually capital intensive. Their volume of business is usually far greater than the owner’s investment.

Multiple of revenue. This valuation, based on gross revenue or gross service revenue, works in firms where profit margins are usually within a narrow range. But profit margins within the design professions vary too much to make this a viable method.

Capitalization of earnings. This method applies a capitalization rate to profits to arrive at value. A certain value is expected to be in place to deliver the level of profits at the assumed capitalization rate. Here again, profit margins in the profession vary so widely that it’s hard to devise one capitalization rate for the industry.

Three guiding valuation principles
Be as simple as possible. Value formulas tend to be complicated. Many include a point-in-time decision that puts a twist on the value. But if something traumatic happens to your firm (a key person dies unexpectedly, for example) a simple formula will minimize argument, speed decision-making and help deter legal challenges.

Keep your books on an accrual basis. Most of your value is in the assets on the accrual side of the balance sheet (work in process, accounts receivable, signed contracts, for example). If you don’t have accrual information, you’ll have to create it for the purpose of determining value.

Real value is determined only when there’s an agreement. Until you have a willing seller and a willing buyer, any valuation is only theoretical.

Book value plus a multiple of earnings
PSMJ Resources Inc. recommends combining book value and earnings. Value is book value plus some multiple of earnings based on several factors, such as goodwill.

Accrual basis book value as it appears in financial statements may be adjusted in a valuation to determine realizable book value. Adjustments might be made for such items as the following:

Unrecorded values. These might include survey records, extensive library materials or proprietary software.

Appraisal assets. The actual value of assets may differ significantly from accounting standards book value.

Deferred taxes. Some firms’ balance sheets carry accrued federal income tax liability associated with the difference between cash and accrual basis income. Since operations and tax planning usually eliminate corporate income tax liability, a valuation expert may eliminate this liability in determining value.

Unrecorded liabilities. These might include, for example, the potential loss after insurance coverage on professional liability claims.

As a rule, keep out of your book value and balance sheet any assets or equity that are not related to the actual conduct of your primary business.

Earnings (Profits)
Earnings are defined as profits from operations before discretionary distributions and expenses (tax avoidance financial transactions). These often include incentive bonuses, ownership-based bonuses and contributions to profit-sharing plans. It’s also appropriate to evaluate compensation paid to owners and others to determine whether their pay is commensurate with what they do for the firm.

Earnings are often averaged or “weighted averaged” over three to five years, so that one year’s unusually high or low earnings doesn’t inappropriately influence the firm’s value.
A multiple to the earnings figure is a subjective factor that is influenced by such factors as reliability and stability of earnings, risk factors, market trends and increased profit potential.

The multiple of earnings
The “multiple of earnings” portion of value is equal to the concept of “goodwill.” Goodwill is the difference between the value of the practice as a going concern and the book value of its net tangible assets. It’s the business advantage the practice has in the marketplace because of factors such as reputation and client quality.

How to prepare for a valuation
The appraiser conducts an office visit to help understand your operation. Then he or she will analyze the following materials:

• Most recent balance sheet
  
• Most recent income/expense statement
  
• Last fiscal year-end financial statement
  
• Previous fiscal year-end financial statement (up to three years’ history)
  
• Profit-sharing, pension fund and/or bonus distributions (up to four years’ history)
  
• Available calculations of project backlog
  
• Current project list
  
• Marketing brochure
  
• Current buy/sell agreement
  
• Strategic plan documentation
  
• Current accounts receivable aging list
  
• Marketing plan documentation
  
• Current employee list
  
• Historical list of number of employees at each of the last four fiscal year ends
  
• Information regarding ownership of any related corporations
  
• Past valuation reports (up to three years)
  
• Other documentation deemed relevant to the determination of the firm’s value

Hire a professional
Because of the unique nature of design firms, you should hire an outside professional with a strong valuation track record to conduct this exercise. Doing so will dramatically increase the chances of your valuation helping you reach your financial goals--whether you are selling your firm, starting an employee stock ownership program or securing additional resources to expand your operations.

Bruce Lynch is vice president of publishing at PSMJ Resources, Inc. in Newton, MA, www.psmj.com.