Category: Business Valuations

What is a Quality of Earnings Report?

A Quality of Earnings (QoE) report is a type of financial due diligence report often prepared as part of a mergers and acquisitions (M&A) transaction.  The depth, period covered, and nature of the analysis included in a Quality of Earnings report can vary depending on the complexity and nature of subject company and its financial reporting, and the perceived areas of risk by the user.

Due to differences in financial reporting practices that vary from company to company, and different accounting standards, the reported net income in a company’s financial statements may not necessarily be a reliable representation of the company’s ability to generate ongoing cash flows. Quality of Earnings does not have a standardized or regulated definition, but generally considers the amount of cash or non-cash earnings, recurring or non-recurring items, the precision of amounts recorded, or those involving estimates that are subject to judgment or change.

A QoE report analyzes the consistency of accounting policies, the degree of subjectivity or estimation, trends in reserves (i.e., warranty, bad debts, inventory, etc.), financial disclosures, and the impact of related party transactions in relation to reported accounting earnings/net income to provide a better understanding of the potential future ongoing cash flows that the business can generate.  Since cash flow is often a key consideration, working capital balances and trends are often analyzed to identify operational requirements and the time required to convert sales to cash.

In a QoE report, the reported earnings are typically normalized to account for items such as non-recurring transactions, non-market transactions, discontinued operations, changes in subjective estimates, and other irregular or non-continuing items. The result is the normalized earnings, which is often measured in earnings before interest, taxes, depreciation, and amortization (EBITDA).

Additional analysis of the company’s financial processes may also be conducted to provide a better understanding of how a company accrues or recognizes revenue and expenses, and the related cash inflows and outflows associated with these transactions.

Sources of information used in a QoE analysis may include financial statements, trial balance reports, general ledgers, company bank statements, and other detailed company financial information.

Why are Quality of Earnings Reports Needed?

A QoE report can be prepared for both the purchaser and the vendor in mergers and acquisitions transactions.

It is common for a purchaser to have a QoE report prepared during the due diligence phase of the transaction to assess potential risks of the transaction and for negotiating purposes. The lender that is financing the transaction or an insurer that is providing representations and warranties coverage may also require the purchaser to have a QoE report prepared to assist with financing or insuring the transaction.

A vendor may also want to have a  QoE report prepared in advance of a transaction to gain a better understanding of areas of the business that can be improved before taking the company to market or to alert them of any potential issues that could negatively impact a sale.

Our Expertise in Quality of Earnings and M&A Transactions

At DJB, our team of specialists have the professional experience to assist prospective buyers and business owners throughout the transaction process. Our trusted professionals can assist in many aspects of mergers and acquisitions transactions, including assisting in the financial and tax due diligence process and preparing Quality of Earnings reports.

 

 

This is the third article in a series on intangible assets and the various valuation methodologies and considerations. Please see our Spring 2024 FSAT newsletter for the first and second articles in our series, ‘Unlocking the Value: Understanding Intangible Assets in Business Valuation’ and ‘Determining the Economic Benefits of Customer-related Intangible Assets.’

In the previous article, we discussed the economic benefits of cultivating customer-related assets. In this article, we will explore the various approaches to value these benefits. The most common approach is the Multi-Period Excess Earnings Method (MEEM), which is often used to value customer-related, technology-related intangible assets, or other intangible assets that could be considered essential to the business. Ideally, the MEEM is selected when the company only has one key intangible asset. The MEEM employs market-participant assumptions and Contributory Asset Charges (CAC) to identify the cash flows directly associated with the intangible asset. CAC are essentially notional charges that are unique to the business and represent the reliance on other assets to support the intangible asset to generate earnings. The assets relied on include working capital, fixed assets, brand/trade name, assembled workforce, non-compete agreements, and more.

As the MEEM is based on the identification of the cash flows directly associated with the intangible asset, such as customer relationships, it is important to consider historical and projected information to develop reliable cash flows. This analysis should consider how long future cash flows from these customer relationships are expected to last. Factors such as the length of the historical customer relationships, renewals, cancellations, and customer switching costs, help us estimate the annual customer attrition rate, which reflects the expected decline in purchases over time. For technology-related assets, this may be referred to as a technological decline that reflects replacement of existing technology or migration to other products.

A disadvantage of the MEEM arises in situations where there are potentially multiple key intangible assets. For example, a business that has built a strong customer base and as a result has a valuable customer relationship intangible asset. This business may also have an exclusive distribution agreement which generates significant revenue. Thus, both the customer relationship and distribution agreement could be key intangible assets of the business. In this case, it can be challenging to isolate and allocate cash flows among the intangible assets, making it difficult to assess the value of the intangible assets separately. Furthermore, proper consideration of the CAC should be analyzed to avoid double counting charges.

An alternative option to the MEEM is the Disaggregated Distributor Method or Distributor Method (DM) which is similar to the MEEM but uses market-based distributor data for the CAC charges and discount rate. This is commonly used in manufacturing industries where sales are transactional in nature and the cost of switching to a competitor is not significant. The DM is only intended to value customer relationships; however, this allows the MEEM approach to be used to value another intangible asset. In addition, it reduces the risk of double counting the CAC which arises when using the MEEM to value two assets. The disadvantage of the DM is the lack of available distributor-related market information.

A third and least common option to value customer relationships is the With-or-Without method which calculates the value of the business with the intangible asset (scenario 1) and without the intangible asset (scenario 2). The difference in value between the two scenarios would be attributed to the customer relationship. This method requires careful consideration of the discount rate for each scenario to ensure risk is not double counted in the cash flows, particularly in the without scenario. Similar to the DM, this allows the MEEM approach to be used to value another intangible asset.

In conclusion, customer-related intangible assets are often valued using the MEEM but occasionally the DM or the With-or-Without method are applied. Properly assessing the unique traits of the intangible asset is essential to facilitate the identification of the approach that would most accurately reflect the value of the customer-related asset.

If you have any questions or require assistance regarding business combinations and valuing distribution agreements, please contact a member of our Financial Services Advisory Team (FSAT) team.

 

Among the approaches or methodologies employed by business valuators to determine the value of a business or equity interest is the market approach. The market approach determines the value of a business or equity interest using one or more methodologies that compare the subject business to similar assets, businesses, business ownership interests, and securities that have been sold or publicly traded. The advantages of using the market approach eliminates some subjective estimates and uses data that is readily available and verifiable. Two commonly applied methods under the market approach are the guideline public company method and the precedent transaction method. In this article, we will focus on the guideline public company method.

The guideline public company methodology is a useful tool in determining the value of a business or equity interest by comparing the subject company to similar companies that are publicly traded. This allows a private business to better understand the price it might receive if it was to trade publicly, based on public companies within a similar industry and similarly sized operations.

There are three steps to prepare a guideline public company comparison:

1. Identifying a list of comparable publicly traded companies and calculating applicable valuation multiples. A valuation multiple is applied to a financial measure such as normalized earnings before interest, taxes, depreciation, and amortization (EBITDA) to develop the value of a business;
2. Adjusting the guideline public company multiples based on the relative size and risk of the comparable public companies in relation to the subject company; and
3. Applying the selected multiples, after any adjustments, to the subject company/interest in order to determine its value.

Identifying comparable public companies and calculating valuation multiples

When identifying comparable public companies, it is important to consider the industry, operation size, location, risk, and diversity of revenue streams of the subject company. For each variable, consider the impact of relevant differences between the selected public comparable companies and the subject company. For example, classifying a restaurant into a full-service restaurant industry versus the fast-food limited service industry could result in different market multiples. Similarly, diversified companies are expected to have different market multiples compared to companies that engage in a specific line of business.

A common misconception is selecting more public companies, will result in a better analysis when the public companies may not be truly comparable to the subject company. Ideally, an average of a number or group of comparable public companies should be used for an accurate analysis.

Once a set of public comparable companies have been identified, valuation multiples are calculated using either the Enterprise Value or Equity Value. Both can be applied to earnings before interest and taxes (EBIT), EBITDA, revenue, or even nonfinancial measures. When calculating the valuation multiples, review the public company’s financial reports for one-time adjustments that may affect EBITDA or the selected measure. The most common valuation multiples use the Enterprise Value, being the “debtfree” approach. The Equity Value may be more relevant and reliable for equity valuations. See our Spring/ Summer 2022 issue of the FSAT News for an in-depth discussion on the differences between Enterprise Value and Equity Value.

Adjusting guideline public company multiples for comparability to private companies

Professional judgment is required to determine the potential discounts that is applicable to the subject company. For example, an inherent minority discount applicable to public traded companies may offset a liquidity discount that is applicable to smaller private companies. The following are common discounts to public company valuation multiples when valuing smaller private companies:

Liquidity discount: The amount by which the en bloc value of a business or ratable value of an interest therein is reduced in recognition of the expectation that the business or equity interest cannot be readily converted to cash.

Minority discount: The reduction from the pro rata portion of the en bloc value of the assets or ownership interests of a business as a whole to reflect the disadvantages of owning a minority shareholding.

Size discount: Large, diversified, and attractive businesses may have little or no discount, whereas smaller companies may have considerable discounts.

Applying selected valuation multiples

Finally, prior to applying the selected Enterprise or Equity Value multiples to the subject company, ensure the earnings of the subject company are “normalized” so they are representative of future maintainable earnings and are similar to the earning measure of the comparable public companies.

The market approach is often used as a secondary methodology or to assess the reasonability of a valuation conclusion. However, it can also be an informative first step if you are considering selling your business or adding a shareholder. To ensure you consider accurate guideline public comparable companies multiples for your business, one of our valuation specialists may be able to assist.

This is the second article in a series on intangible assets and the various valuation methodologies and considerations. First article: Unlocking the Value: Understanding Intangible Assets in Business Valuation

Customer-related intangible assets present insight on customers and their buying patterns. This can be analyzed to execute the development of new products or services, align a company’s strategic initiatives, or expand to new markets and geographic locations. Examples of customer-related intangible assets include customer lists, customer relationships, and customer contracts.

Organic growth vs. Inorganic growth

A business can grow through two categories: organic growth and inorganic growth. Organic growth is natural growth from existing operations, such as selling more products, reducing costs, or improving efficiency.

In contrast, inorganic growth is rapid growth of a business through acquisition or expansion resulting in an immediate increase in market share. Through a business acquisition, a competitor’s customer-related intangible assets can also be obtained to gain a competitive advantage. Accordingly, customer-related intangible assets are a commonly identified intangible asset in a business acquisition.

In this article, we address some of the nuances in valuing a customer-related intangible because of a business acquisition.

Customer lists vs. Customer relationships

A customer list contains customer information, such as personal, behavioural, or demographic data and can even potentially be re-sold. A purchaser can use this information to determine a target demographic when marketing new products and services or expanding existing product offerings.

A customer relationship is based on a history of sales transactions. The value of a customer relationship depends on how often purchases are made, the friction or costs to find and replace customers, and how dependent those customers are on the business. The benefits of a strong customer relationship include customer retention, loyalty, referrals, and satisfaction. A contract does not need to exist for a customer relationship to have value, as long as there is an expectation of the relationship to continue.

Customer contracts

Customer contracts not only provide an estimate of future profits, they can also provide economic reassurance to the purchaser during a business acquisition. A contract can exist in various forms such as verbal, written, express, or implied. An intangible asset can exist as long as the contract is legally enforceable. The specific contract terms are reviewed when determining the value of a customer contract.

In addition, customer’s purchasing patterns, length of the relationship, and potential of renewal also need to be reviewed to meet specific financial reporting and accounting standard requirements when valuing intangible assets in relation to the definition of fair value.

Customer attrition rate

Customer attrition is the expected future loss of customers or decline in future customer purchases and is based on historical revenue or customer count to provide an indication of future expectations. The selection of the customer attrition rate is based on historical data, future forecasts, and the following factors:

Customer segmentation: Separating customers based on their as personal, behavioural, or demographic data will improve accuracy of the customer attrition rate.

Loss occurring at a variable or constant rate: The rate of customer loss can occur early in the relationship, later in the relationship, or be constant regardless of the age of the relationship. The telecommunication industry has a high rate of customer loss early in the relationship because of competition and relative ease for customers to switch providers.

When a customer is considered “lost” can vary depending on the product or service offered. For a music or video streaming service, a customer may be considered lost after cancellation as the relationship can end very easily. However, for a home appliance or home furnishings store, a customer may not be considered lost until five years have passed with no sales due to the periodic and large nature of purchases from those stores.

If you have any questions or require assistance regarding business combinations and valuing customer-related intangible assets, please contact a member of our Financial Services Advisory Team (FSAT) team.

 

 

Introduction:

When an acquiror obtains control of a business, both the International Financial Reporting Standards (IFRS) 3 Business Combination and Accounting Standards for Private Enterprises (ASPE) Section 1582 require a fair value measurement for assets acquired and liabilities assumed. Unraveling the layers of intangible assets becomes pivotal, and the purchaser’s motivation sheds light on identifying and determining the significance of the intangible assets acquired.

This is the first of a series of articles on intangible assets and the various valuation methodologies and considerations.

The focus of this article is an overview and discussion of the five categories of identified intangible assets and the difference between fair value and fair market value, exploring the characteristics and considerations that play a key role in a valuation.

Five Categories of Identifiable Intangible Assets:

There are five distinctive categories of identifiable intangible assets, encompassing a range of elements vital to business operations. These include, but are not limited to the following:

1. Marketing-related: Trademarks, trade names, and non-compete agreements.
2. Customer-related: Customer lists, customer relationships, and customer contracts.
3. Contract-based: Licensing, supply agreements, royalty agreements, and lease agreements.
4. Technology-based: Computer software, databases, and trade secrets/formulations.
5. Artistic-related: Books, scripts, music, and movies.

Fair Value vs. Fair Market Value

IFRS 3 requires intangible assets to be valued using IFRS 13’s definition of fair value: “as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

ASPE 1582 requires intangibles assets valued in a business combination to use the following definition of fair value: “the amount of the consideration that would be agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act.”

In Canada, the definition of fair market value in business valuations is generally defined as: “the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell when both have reasonable knowledge of the relevant facts.”

While the definitions are similar, they are not identical and may lead to a difference in assumptions and have an overall impact to the valuation conclusion.

Conclusion:

Navigating the intricacies of business combinations and the valuation of intangible assets requires expertise and precision. For inquiries or assistance in this domain, our Financial Services Advisory Team (FSAT) is ready to guide you through the valuation process and provide assistance. Your understanding of these intangible assets is the key to unlocking the true value embedded in your business.

Businesses with active operations are commonly valued based on their ability to generate earnings or cash flow. For mature businesses that demonstrate consistent earnings or cash flow, a Chartered Business Valuator (CBV) or other valuation practitioner may employ a capitalized earnings or cash flow methodology to assess the value of the business operations if future results are expected to be stable. Under this type of methodology, historical business results are analyzed to estimate a sustainable level of earnings or cash flow. A capitalization rate or multiple is then applied to determine the hypothetical amount an investor would pay for the business operations.

In order to determine the sustainable level of earnings or cash flow a business can generate, historical results are reviewed. Adjustments are made to the reported results to arrive at “normalized” earnings or cash flow, which are then considered when selecting the sustainable level or range. Below are some examples of common normalizing adjustments made to determine a business’s normalized earnings or cash flow:

Related Party Transactions

Businesses often have transactions with related individuals (such as shareholders or their family members) and companies controlled by these individuals. These transactions may involve discretionary payments or do not always reflect the economic value transferred. When normalizing earnings or cash flow, these transactions are typically adjusted to market rates that would be paid or received from an arm’s-length (unrelated) party. Examples include compensation paid to owners or their family members working in the business, rent for real estate or equipment owned by a related individual or corporation, sales or purchases with related entities, and consulting or management fees. These can be in the normal course of business, but they may sometimes be for other purposes such as tax planning.

Redundant Asset Adjustments

Businesses may own redundant assets — assets not used in active operations. Under an income approach, the value of redundant assets is considered separately from the value of business operations to avoid double counting. Income or expenses related to these redundant assets are removed from normalized earnings. Examples include dividend or interest income from marketable securities and loans, investment management fees, and life insurance premiums. If a business owns real estate not essential for operations, treating it as a redundant asset involves adjusting earnings by adding back ownership costs and deducting a “market” rental rate.

Non-Recurring and Non-Operating Adjustments

Non-recurring items are amounts that are not expected to occur in the future on a predictable basis. Examples of non-recurring items include lawsuit settlements, moving costs, discontinued operations, and revenue from one-time projects. These nonrecurring revenues and expenses are removed from normalized earnings/ cash flow. Non-operating expenses are also removed and include personal expenses paid by a business on behalf of a shareholder.

Selecting a Maintainable Level:

There is no precise method or formula to determine the maintainable earnings of a business. Normalized historical results are one factor among others considered when estimating the maintainable future earnings for valuing business operations. Other factors include short-term budgets/forecasts, industry and economic data, management input on the future business outlook, and the professional judgment of the valuation practitioner.

If you have any questions regarding your business’s earnings or cash flow, please contact a member of our Financial Services Advisory Team (FSAT) team.

 

In this article, we discuss some of the ways a Chartered Business Valuator (CBV) is often asked to assist in various legal matters.

CBVs and Litigation

In litigation, CBVs are often involved as either independent “expert witnesses” or non-independent litigation consultants.

Expert Witnesses

• An expert witness is an opinion witness of the court. An opinion witness does not have direct involvement in the matter that is before the proceeding until after the incident occurred, and is relied on to provide an opinion on the matter based on their specific expertise. This is different from a fact witness, which is a person who has direct involvement in the matter.
• An expert is a person with specialized skills, knowledge, experience, or training in a specific subject matter area that is pertinent to the legal proceeding. To be an expert witness, the expert must be clear of any conflicts.
• Prior to becoming an expert witness, the expert prepares an expert report to be used as evidence in litigation. Experts must be accepted by the court and qualified as an expert witness at the time of trial to testify in a proceeding related to matters of their specific expertise.
• An expert witness must be independent and objective, and it is their duty to assist the court impartially on matters relevant to their area of expertise.

CBVs as Expert Witnesses

CBVs are regularly relied on in legal proceedings to assist in the following areas:

• Disputes where a business valuation is required;
• Dispute-related matters such as shareholder, intellectual property, contract, and matrimonial disputes;
• Quantification of economic/ financial losses; or
• Other conclusions of a financial nature.

A CBV may be asked to prepare an independent written report, which will be entered as an exhibit in litigation. This report is known as an “expert report”, which is a written communication containing a conclusion as to the quantum of financial loss, or any conclusion of a financial nature in the context of litigation or a dispute, prepared by an expert acting independently. In situations where the fair market value of a business or asset/liability is required, an expert report may contain a valuation conclusion.

A CBV may also prepare a limited critique report, which has the purpose of commenting on another expert’s report but does not include a separate financial conclusion. In a limited critique report, comments are provided with respect to the approach and techniques used and calculations in the original report, subjective matters such as the selection of discount rates, and whether the original report is suitable for the purpose at hand.

CBVs as Litigation Consultants

A CBV can also assist clients in litigation matters as a litigation consultant. In this case, the CBV will act as an advisor to legal counsel to promote the interests of their client. In this situation, a CBV is not considered independent, and would not be able to act as an independent expert witness during the trial or in other future litigation on this matter. In this role, a CBV generally acts as an advisor to legal counsel, will provide advice, support their client in various processes, and may advocate on their client’s behalf. Because certain valuation principles and topics are often subject to interpretation and professional judgment, the consultant is often relied on to assist the client to advance their own position in the litigation process. The litigation consultant can assist with such issues as strategy and cross-examination. A CBV acting as a litigation consultant is not independent and will not be required to testify. In some situations where a CBV is engaged as a litigation consultant, the CBV may be covered by litigation privilege.

CBVs and Family Law

CBVs are regularly involved in family law matters. CBVs are most often involved in assisting in valuation determinations related to the division of property on marriage breakdown and the determination of income for spousal or child support purposes.

If you have any questions regarding how a CBV can assist you in legal matters, please contact a member of our Financial Services Advisory Team (FSAT) team.

NOTE: This article is not intended to be legal advice. Please contact a lawyer to discuss the legal implications discussed in this article further.

Who are minority shareholders?

A minority shareholder is any shareholder who does not own a controlling interest in a public or privately-held company.

What is a minority discount?

In a notional valuation context, a minority discount is when the pro rata value of a particular minority shareholding is reduced to reflect the disadvantages of owning a minority interest of an asset or security
as a whole. Typically, a minority shareholding realizes a discount for:

• The inherent lack of marketability or illiquidity, which refers to assets or securities that cannot be sold and converted to cash without a loss in value. Minority shareholdings are generally viewed as less marketable or liquid than a controlling interest, therefore attracting fewer potential buyers resulting in a discount. Sometimes referred to as Discount for Lack of Marketability or DLOM; and
• The lack of control over the company’s operations and the ability to influence the future direction of the company and the distribution of profits/dividends. Sometimes referred to as Discount for Lack of Control or DLOC.

The level of minority discount can range significantly depending on the facts of the particular situation and ownership interest held.

Minority shareholders in a publicly traded company vs. a privately-held company

Minority shares in a publicly traded

company, where shares are widely held and large volumes of share are frequently traded, usually has a minimal illiquidity discount. While minority shareholders have no control over the direction of the public company, they can choose whether to sell or hold the company’s shares. As a result, there is often no significant discount for illiquidity or lack of control.

In contrast, a privately-held company’s en bloc value may already reflect a general illiquidity discount as there is no ready market available to buy or sell shares in a privately-held company. A further discount for

illiquidity may apply specifically to a minority shareholder, compared to a controlling shareholder of the same privately-held company.

Factors influencing discount

While the specific methods and possible empirical evidence are outside of the scope of this article, the quantum of the discount for lack of control and lack of marketability, which are sometimes combined into one discount, is dependent on several factors, including the following factors:

• Shareholder’s level of involvement in the business.
• A shareholder who is on the board of directors or involved in the daily operations of the business would generally have a lower quantum of discount than a shareholder who has no involvement in the business operations or governance.
• Relationship and size of the shareholding relative to the other shareholdings.
• In scenarios where there are no controlling shareholder, the relationship and combination of the size of the subject shareholding with other minority shareholders must be considered to determine if the subject shareholder can influence decisions.
• Additionally, the applicable minority discount may be less or a potential premium may be available, if the other minority shareholders want to purchase the subject’s shares in order to become a majority shareholder.

Shareholders’ agreements

• Clauses that influence liquidity or control will have influence on the quantum of a discount, such as restrictions on share transfer, rights of first refusal, or tag-along/drag-along provisions.

Nuisance value

• Shareholders who hold just enough shareholdings to prevent or delay the plans of a controlling shareholder are considered to have “nuisance value” and may have a lower quantum of discount.
• It is difficult to determine the discount for nuisance value in a notional valuation.

Family or group control

• Shareholders who act in concert and in aggregate owns over 50% of the shares, may not have an applicable minority discount. However, a third party who enters into a shareholder agreement may have a significant minority discount applied to the value of their shares.

Dividends

• A history of dividend distribution is an indication of return on investment and may indicate less of a minority discount.

Prior sales of minority shareholdings

• Prior transactions provide insight regarding the quantum of any minority discount.

To apply a minority discount or not?

To determine whether a minority discount applies, consider the following two factors: the purpose of the valuation and the valuator’s professional judgment. If the valuation were to determine the value of the minority’s interest for the purpose of a sale to a non-related party, a minority discount would apply. The quantum of the discount that applies to the sale requires a valuator’s professional judgment and analysis.

In shareholder disputes involving oppression, one of the remedies is to have the corporation purchase the oppressed minority shareholder’s interest at fair value. In this case, a minority discount would not apply.If you have any questions or require assistance with determining if a minority discount is applicable and the quantum of the discount, please contact a member of our Financial Services Advisory Team (FSAT) team.

Assets owned by an operating company can be divided into three broad categories in a business valuation:

1. Tangible assets (i.e., assets that have a physical substance) required for day-to-day operations of the business;
2. Goodwill and intangible assets such as patents, tradenames/ brands, or customer lists which do not appear on the balance sheet unless they have been acquired in a transaction; and
3. Redundant assets which are typically physical assets not required by a business for ongoing operations.

In a business valuation, tangible assets, goodwill, and intangible assets usually form part of the going concern value, which is the value of a business enterprise that is expected to continue to operate into the future.

However, redundant assets do not form part of the going concern value as they are not required for operations. A potential buyer considering purchasing a business would only be interested in purchasing the assets that are used by the business to generate operating income. Therefore, redundant assets are not included in the value of the business operations. Instead, the value of redundant assets are added in addition to the value of the business operations to determine the fair market value of the en bloc share value or equity value of the business.

Examples of typical redundant assets:

• Excess working capital
• Marketable securities
• Due from shareholder/related companies
• Personal assets (i.e., artwork, vehicles, etc.)
• Real estate
• Life insurance policies

Redundant liabilities

Redundant assets increase the en bloc share value of the corporation. Conversely, redundant liabilities are items that reduce the en bloc share value of the corporate and can include non-operating loans such as loans to purchase a personal vehicle or due to shareholders/related parties. Identifying redundant assets or liabilities In some situations items that are typically redundant assets may actually be required for operations of the business depending on the nature of the business and its operations. For example, a life insurance policy which is needed as part of a loan covenant/ external lending requirement. As a result, the particular life insurance policy may not be considered redundant.

Real estate as a redundant asset

Generally, when a company does not directly rely on its real estate (i.e., land and building) to generate its revenue, real estate is often considered redundant. However, consideration must be given to the business industry and availability of rental space for operations, among other factors.

In a notional business valuation situation, businesses with real estate typically engage the services of a professional real estate appraiser to determine the fair market value of the property. In addition, when assessing the value of a business using the income approach, an adjustment to normalized cash flow should be made for the amount that would need to be paid if the operating space was rented at market rates from a third party.

Excess working capital

Working capital, (i.e., accounts receivable, prepaid expenses, inventory, less accounts payable) is the amount required to keep operations running and meet short-term daily obligations. If a business does not have sufficient working capital, it may require additional funding/investment to operate. Therefore determining the required level of normal working capital is essential and involves a review of the business, industry ratios, and banking covenants.

Once a required level of working capital is identified, any excess working capital is deemed redundant and removed from the business. During a sale of a business, if there is a deficiency in working capital, a reduction to the transaction price will be made to retain cash in the business.

In a disposal of redundant assets (often during an asset purchase of a business), disposal cost and tax consequences need to be considered such as taxable capital gains/losses, recapture/terminal loss, and income taxes. When a notional business valuation is prepared, the tax consequences are also considered, but may require some discount to account for the fact that the redundant assets will likely be sold at some point in the future, and not at the valuation date.

Conclusion

Proper identification of redundant assets/liabilities and determining an appropriate level of working capital are some important factors in determining an accurate value of a business.

If you would like more information on the topic or assistance in determining the value of your business, please contact our valuation specialists.