The value of "it"

by Erin Hollis

A balance sheet doesn’t tell an owner the company’s true worth, or fair market value. The difference between a company’s book value and its fair market value is its intangible value.

A study conducted by business consultants Richard Boulton, Barry Libert and Steve Samek compared the market values and book values of 3,500 U.S. companies over a 20-year period. Their findings indicate that in 1978, a company’s book value was 95 percent of its market value; however, in 1998, book value accounted for a mere 28 percent of a company’s market value. An unrelated study conducted by the Brookings Institute showed that in 1978, 20 percent of corporate value was attributable to intangible assets, whereas in 1998, the amount had increased sharply to 80 percent.

Job shops are highly asset-intensive companies, and a significant portion of company profits are committed to reinvesting in equipment versus filling shareholder pockets. Yet, business owners shouldn’t look only to the balance sheet to assess their company’s worth. With all of its infinite traditional accounting wisdom, the balance sheet only tells an owner the company’s book value. "Book Value" or "Net Worth" or "Shareholders’ Equity" are fancy terms for describing the mathematical difference between everything the company owns less everything the company owes. What the balance sheet doesn’t tell an owner is the company’s true worth, also commonly referred to as fair market value.

Basically, the difference between a company’s book value and its fair market value is its intangible value or goodwill value. Intangibles are assets untouchable by the human hand, yet their influence on a company’s fair market value has the impact of Muhammad Ali’s legendary left hook at Madison Square Garden. Intangibles give a company the "it" factor. Customers give a company repeat business and referrals because of "it". Companies are able to lure customers away from competitors because of "it". A company with "it" can successfully price its products higher than the competition.

Fortunately, business owners can capture the value of "it" and assess their company’s total worth utilizing a third-party business appraisal. Credentialed business appraisers, experienced in valuing manufacturing operations, assess all tangible and intangible elements and other factors in arriving at the value of the business.

What is a business valuation?

The share value of publicly traded companies is easily assessed by looking in the business section of the daily newspaper, locating the stock tables and multiplying the closing price by the number of shares owned. However, there is no convenient stock table to assess the share value of privately held companies. That value can be accurately determined only through a professional business valuation. A business valuation assesses the worth of an enterprise from various perspectives and takes into account everything tangible and intangible that surrounds the business. It examines the business on its own merit, how it compares to similar companies in the industry and how it rates in the marketplace.

A manufacturer’s intangible value

According to Baruch Lev, a recognized accounting authority and professor at New York University’s Leonard N. Stern School of Business, intangibles are generated by three elements: innovation, organizational design and human resources. This couldn’t be more accurate for manufacturers. Experience, a good reputation, maintaining customer loyalty and quality customer service are essential to success in business. Specific to fabricators, there are other intangibles and goodwill factors that foster success and increase the company’s value.

Intangibles driven by innovation include:

• Established relationships with suppliers and other manufacturers;
• Research and development;
• A company Web site that provides information about products and services for existing and potential customers;
• Ongoing enhancements for continuous, improved operations, such as adding automated machinery to provide quick deliveries, competitive pricing, minimizing material handling and adding a production shift without investing in more labor;
• Embracing the global economy and finding ways to reduce labor costs to keep pricing competitive;
• Patents, copyrights, brand names and trademarks;
• Designs and technology, including information technology.

Intangibles generated by organizational design include:

• A sales and marketing plan that provides sufficient orders to run machines throughout the day and have enough orders to cover multiple shifts;
• Processes for minimizing waste to reduce costs;
• Production plans for reducing non-value added steps, setup times and changeover times;
• Plans that make better use of floor space by reducing work-in-progress or parts not needed immediately.

Human resource motivated intangibles include:

• A strong engineering staff and technology team;
• Employee training, both preventative and ongoing (including safety training), to gain skilled workers and reduce equipment repairs and waste;
• Favorable working conditions and salaries to retain skilled employees.

Owners take heed

Without sufficient industry knowledge, someone other than an experienced appraiser might apply an incorrect valuation method, resulting in an inaccurate assessment of worth. Furthermore, an appraiser unfamiliar with the types of intangible assets specific to the manufacturing industry may focus too heavily on the tangible assets, missing the important contribution intangibles that contribute to the company’s value. Correctly assessed intangibles can drive a manufacturer’s total market value by up to 50 percent, so business owners should heed the warning: You get what you pay for. A credible valuation professional will not quote EBITDA (earnings before interest, taxes, depreciation and amortization) multiples or industry rules of thumb to get your business. So-called appraisers who do may be really only interested in selling a business for a brokerage commission and will charge owners far less for the valuation than a reputable appraiser. The fee for a credentialed appraisal conducted by a professional with industry experience is approximately $15,000. Sometimes it can even be higher. Before signing on the dotted line, check the appraiser’s credentials, which should be from a professional valuation organization, such as the National Association of Certified Valuation Analysts or the American Society of Appraisers.

An experienced professional will know key manufacturing industry valuation issues such as:

• Machinery. How often does machinery need to be purchased or updated? Is the company able to purchase new equipment regularly or is existing machinery refurbished? Does the company have machinery requiring only highly experienced technicians? Does the company have automated machinery?
• Certifications & Education. Is the company ISO-certified? How are employees educated on new machinery and techniques?
• Litigation. Has the company been the focus of litigious claims or events, such as workman’s compensation or environmental issues?
• Employees. What is the level of skill necessary to run the machinery? Is the company union-affiliated? What is the level of turnover? How are experienced journeymen retained? What benefits are offered and can the company afford to maintain those benefits?
• Pricing. How are jobs priced? How has the rise in material costs affected the company? Are labor costs depleting gross profits?
• Competition. How are new clients gained and existing clients retained? What does the company do that sets it apart from the competition?

Key benefits of a business valuation

Think of the business valuation as a multifunctional tool. Although it may be more expensive than a metal cutting tool or a metal forming tool, it still provides a cost benefit to the company. A business valuation is an owner’s multifunctional planning tool. By knowing the value of his or her business, an owner is able to answer important questions such as:

• What if I get an unexpected offer from a potential buyer? If you receive an unsolicited offer to sell the business, you may not have time to wait to have an appraisal completed. Having a current valuation will enable you to make informed decisions quickly.
• What’s my exit strategy? Will I sell to a third party, gift (or transfer) to a family member or sell to a key employee, etc.?
• Do I have adequate life insurance for my business needs? Knowing the worth of a business is a prerequisite for assessing the required amount of key-person life insurance and funding buy-sell agreements among shareholders.
• What’s the return on my investment (ROI)? Establishing a value to compare to the owner’s original investment provides a reasonable estimate of the ROI. Identifying the strengths and weaknesses of the business allows an owner to focus on areas where improvement will significantly enhance its future market value.
• Will I be able to obtain financing? A valuation provides lenders with additional due diligence from an independent third party to assist in the process of qualifying applicants.
• How much money will I need for retirement? If an owner desires to sell the business and utilize the sale proceeds to fund his or her retirement, regular business valuations are vital in benchmarking the value toward achieving financial goals.
• How much is my estate worth? An accurate determination of the value of a business owner’s estate (which includes the value of his/her business interest) enables the owner to implement adequate estate tax minimization strategies.

Keep it current

At a minimum, business valuations need to be conducted at least every two years. However, a good rule of thumb to use when considering how often to engage in a valuation is based on three factors:

• When a significant change in assets occurs. The company makes a substantial investment in equipment or other tangible assets, or sales change notably.
• When tax laws change. Tax laws are constantly changing. An owner must keep abreast of those issues that may affect him or her.
• When intentions change. Personal reasons (marriage, divorce, etc.) or professional reasons (bringing in new or buying out shareholders, rewarding key employees).

For most manufacturers, their business is their most valuable investment, yet very few are able to say with any level of confidence what it is worth. Approximately 75 percent of business owners invest their own net worth in the business and many never see the materialization of the full investment again. Business owners, who have nurtured their investments and have grown the company from a modest-sized manufacturing operation, want their businesses to continue to thrive. Intangibles give the company the "it" factor and can increase business value substantially. Likewise, not including intangibles seriously undervalues the company. A properly prepared business valuation that includes all intangible aspects of the business provides owners numerous benefits and is more than a mere calculation of numbers. It is a valuable financial planning tool that captures your company’s entire value.