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Valuation Methods for Small Businesses

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There are numerous reasons you may  want to know the value of your company. In addition to reasons related to a potential sale of the business and allocation of the purchase price to various assets or asset classes, valuation is also important for other purposes such as mergers, business conversions, borrowing, shareholder/member/partner agreements or disputes, estate tax valuation or buyout upon the death of a member, and gifting for estate planning. Many times, appraisals by certified appraisers are necessary or advisable.   

Below are some common valuation methods for small businesses. Valuation professionals often use varied approaches to find a balanced, well-rounded number that more accurately depicts your company’s value. 

1. The Multiple of Earnings Approach

Many valuations are based on a multiple of earnings before taxes, interest, depreciation and amortization (“EBITDA”).  This provides a measure of a company’s operating performance, excluding non-operating expenses and non-cash charges.  

Multipliers vary based on industry, market volatility, business location, risks, and many other factors. Often, the higher the EBITDA, the higher the multiplier will be.

Next, EBITDA will be “normalized,” or adjusted for unusual or non-recurring items. This adjustment provides a more accurate measure of the businesses “normal” operations.

Normalized EBITDA will often be further adjusted to determine the seller’s discretionary earnings (“SDE”), to provide a measure of expected financial value a new owner would gain on an annual basis. These adjustments are sometimes referred to as “add backs” and typically include owner’s compensation, perks and benefits, as well as excess expenses paid to related parties, such as rent if those expenses exceed market value.

Lastly, normalized EBITDA or SDE may be further adjusted, or weighted, so as to give more effect to recent earnings than earnings from two, three or more years ago. This may be referred to as a “weighted average” of earnings over the prior three to five years.

Finally, the valuation professional will determine the appropriate multiplier for your business.  This multiplier will be based on many factors, including the nature of your business, recent transactions in the same and similar industries, and various other market conditions and risk factors.  Often the multiplier is between 3 and 5, however, but could be lower or higher.

2. The Discounted Cash Flow or Capitalization of Earnings Method

The discounted cash flow or capitalization of earnings methods rely heavily on many of the same earnings calculations discussed above; however, rather than applying a multiplier to one year’s earnings, this method projects earnings for a number of years and then discounts that stream of income to its present value.  Instead of a multiplier, the valuation professional must determine a “discount rate” or “capitalization rate” which will reflect a number of different factors such as interest rates, inflation, business risk, etc. 

3. The Adjusted Net Asset Method

Some valuation methods for small businesses focus solely on business assets rather than cash flow, revenue, or earnings. The Adjusted Net Asset Method looks at the monetary value ofyour business’s tangible assets such as real property, furniture, fixtures, and equipment, inventory, accounts receivable, etc., net of loans, financing, payables, and other liabilities. This method is more appropriate for asset heavy businesses as opposed to service businesses and operating companies.

Work With a Business Law Attorney for Personalized Support

Again, there are many reasons you may need or want to value your business.  Typically, a business valuation professional will be advisable or required.At Wilson Ratledge PLLC, our business law attorneys can help you with whatever needs you have that might require valuation, from succession and estate planning, to selling your business.  We can also help you understand the many factors that go into the valuation, and how they affect your needs, plans and goals.a.

Call Wilson Ratledge PLLC today at 919-787-7711 to schedule a consultation with our team. 

Key Steps Before Selling Your Business

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If you’re considering selling your business, there are several things you should consider before taking that life-changing step. Your business sale will be more fruitful with the right preparation. So, what steps should you take before closing the deal?

1. Evaluate the Timing

If you’re not under any particular compulsion to sell now, you will want to evaluate whether the timing is right. You can determine timing favorability by looking at market conditions, competition in your area or industry, consumer demand levels, and more. Ask yourself whether you’re in a buyer’s or seller’s market to better understand your positioning. 

2. Prepare Your Business for Sale or Acquisition

Like selling a house, before putting your business on the market, you must prepare it for sale. To do so, it helps to gather the following due diligence materials: 

  • Governing documents (bylaws, shareholder agreement, operating agreements, annual meeting minutes, etc.
  • Financial statements (previous three years and current year to date)
  • Tax returns
  • Employment contracts and benefits information
  • Leases (equipment and real property)
  • Loan agreement
  • Business licensing, permits, and certifications
  • Any other contracts and other relevant documents that will impact the transaction and/or your buyer after closing

Be prepared to disclose any legal matters, such as pending or threatened lawsuits, tax audits, etc. The potential buyer will look into your business’s financial records, tax filings, governance and legal matters, and more to understand purchase risks and profitability. After entering into confidentiality agreement (whether before or as part of the Letter of Intent (LOI), you should offer transparency early to prevent wasted time and effort, or soured relationships with your buyer.

Advance work with a transactional/mergers & acquisitions attorney will help you present your due diligence materials in an organized and effective manner, and will help you spot potential issues and address them before your buyer raises them.

3. Discuss Business Goals and Transition/Post-Closing Integration Plans Early On

In transaction negotiations, an early understanding of the “business case” for the deal will help all parties determine whether the investment of time and resources in moving forward with legal contracts (referred to as “definitive agreements”) is worthwhile. 

What will your involvement be after closing? Do you and the buyer agree on transition plans and integration strategy, including branding changes, maybe a new company name, and long-term business goals? Will you need to hire or fire any employees, or can you keep your current staff? Are you planning to enter any new markets or develop any new products or services?

You should discuss these types of questions with the potential buyer early in the process to streamline transaction and minimize surprises later on.

4. Seek Objective Valuation

Sellers often have strong opinions about what their business is worth.  And, to be fair, what a seller is willing to accept is a significant factor in determining the value of a business, but it is not the only one. It is important for any seller to understand the fair market value of the business for sale, which is an objective, professional estimation of what a fair price for the business would be.

Business valuation professionals consider factors like, among others, cash flow, profitability (you’ve heard of EBITDA-earnings before interest, taxes, depreciation and amortization-and SDE-seller’s discretionary earnings), total assets, current market conditions, and forecasted growth to estimate a business’s fair market value (FMV). Being armed with this knowledge will help you in meaningful negotiations of a purchase price with your buyer.

5. Involve Your Landlord, Lender, and Other Necessary Parties early

Whether selling or merging your business, you should discuss the anticipated transaction early on to get their participation and any necessary consents and agreements to allow the transaction to proceed under the terms of your agreements with them. Your attorney can provide valuable insight by reviewing the applicable documents first so that communications with these third parties can be targeted and efficient, tailored to the terms of your specific agreements. 

6. Study the Tax Implications

Business sales, and other mergers and acquisitions involve numerous tax implications that can impact you significantly. These are outside the scope of this post, but suffice it to say you should consult a competent CPA and get good tax advice before you sign a LOI. Seller’s and buyer’s have different tax motivations, and these are a significant factor in negotiating the purchase price and structure of your transaction. 

7. Be Thorough in the Letter of Intent

Include as many primary points of negotiation in your Letter of Intent as possible. This makes it critical to seek competent legal advice before entering into your LOI. Besides purchase price and structure, involving legal counsel at this stage will help you structure the transaction consistent with your expectations not only financially, but also from a tax perspective, legally, and expectations for post-closing issues related to earn-outs, indemnification, and others.  In addition, depending on the structure of the deal (with very few being strictly cash at closing, you will want to conduct due diligence on your buyer to achieve some comfort level with their financial history and capabilities, credit, existing debts, legal documents, management team, and more to ensure they can fulfill their obligations under the purchase agreements and that you will be able to work with them after closing, if that is part of the deal.

8. Keep the Merger or Sale Confidential

Many transactions these days are “simultaneous sign and close”.  This means, in the words of Yogi Berra, “it ain’t over ‘til it’s over.”  Announcing any preliminary news before finalizing the sale can cause any number of problems, which can not only endanger the transaction, but also haunt you going forward if the transaction does not close. By keeping the sale confidential, you can protect your team while ensuring the sales process continues progressing smoothly. Do not post on social media, announce the sale in your newsletter, or anything else.

Work With a Transactional/Mergers & Acquisitions (“M&A”) Law Attorney for Support from Start to Finish

Do you need help selling or merging your business? Wilson Ratledge, PLLC, can guide you through the process to protect your financial interests. Call Wilson Ratledge, PLLC, today at 919-787-7711 to speak with a business law attorney. 

Introduction to Mergers and Acquisitions for Small Businesses

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The Institute for Mergers, Acquisitions and Alliances reports that almost 400,000 M&A transactions have occurred in the U.S. since 1985. This includes nearly 15,000 in 2023 alone.  While recent uncertainty and higher interest rates have suppressed M&A activity recently, mergers and acquisitions are poised to trend upward in the coming months and 2025 due to multiple factors, including lower interest rates and a strong economy.

Is your small business preparing for a merger or acquisition? Are you one of the many business owners of a certain generation looking at selling your business as your exit strategy? Start to familiarize yourself with the process before you put your business on the market.

What Are Mergers and Acquisitions?

“Mergers and acquisitions” (or “M&A”) is the general term for all manner of transactions in which businesses change hands.  While some people use the terms “merger” and “acquisition” interchangeably; they are different concepts. Understand what separates the two before addressing one or the other.

Mergers

A merger occurs when two companies merge, and only one survives or they combine to create a new company in pursuit of greater collective success than the the two companies would have by continuing as separate businesses.

An example is Extra Space Storage Inc. and Life Storage, Inc. merged in 2023 to become the biggest U.S. storage business operator.

Mergers typically involve similarly sized companies and are designed to advance companies to the next level within their respective industries.

Acquisitions

An acquisition is when a person or a company (the “acquirer”) buys another company (the “target”) and becomes the new owner. A company usually acquires another company to expand into a new business sector or to strengthen its industry standing.

An example is Amazon’s acquisition of Whole Foods in 2017, which enabled the tech giant to expand into the grocery industry.

Usually, an acquisition involves the willing participation of two companies. However, it can also include a hostile takeover, in which shares of a company that doesn’t necessarily want to be purchased are purchased from the company’s shareholders without the participation or approval of the target’s board of directors.

While we have mentioned several large, public companies, M&A issues are critical in the life of small and medium-sized businesses as well.  There is also a growing movement of “entrepreneurship through acquisition” (or “ETA”) where young entrepreneurs are choosing to buy existing small businesses instead of starting from scratch. 

DifferentTypes of Mergers and Acquisitions

There are several specific types of M&A, including:

  • Mergers (or Consolidations): When companies combine to improve their market share and reduce competition, or achieve economies of scale or synergy 
  • Stock purchases: When one company buys outstanding stock from another company
  • Asset Purchases: When one company purchases assets from another company
  • Management acquisitions: When executives from one company secure a controlling stake in another company

Factors To Consider Before Mergers and Acquisitions

Mergers and acquisitions for small businesses are common, but it is important to prepare yourself and your company before entering into any transaction. Start by familiarizing yourself with various elements of M&A so you and your business will be better prepared to engage meaningfully in the transaction negotiation and process. 

1. Types of M&A Transactions

First and foremost, what is the purpose of the transaction? While a seller or target may not be as invested in this question as the acquirer, most of the time, the seller’s benefit is at least partially dependent on what happens after closing.  For this reason, it is important for a seller to understand the “business case” for the transaction and understand what will happen after closing to ensure the seller achieves the anticipated results of the deal.

Here are some examples of strategic goals of an M&A transaction :

  • Horizontal Integration: Involving two companies operating within the same industry and selling the same products and/or services
  • Vertical Integration: For example, when a company buys a supplier 
  • Congeneric or Concentric:Involving two companies serving the same customers with different products and/or services merge
  • Conglomeration: Involving two businesses in unrelated industries and markets, typically for diversification purposes.

2. How To Finance a Transaction

Second, how will the purchase price be paid?  When one company plans to purchase another, it must first work out acquisition financing. A company can buy another company using:

  • Cash
  • Stock
  • Assumption of debt
  • Seller financing
  • Earnouts

A company can also use more than one of these options to acquire another company.  Relatively few transactions result in 100% cash to seller at closing, so you will want to protect yourself against post-closing risks to your purchase price.

3. How To Value a Target

Finally, and most critically, before a merger or acquisition, the acquirer and the target/seller must agree on valuation. This is tricky in acquisitions, in particular, since a buyer will want to acquire a targetfor the lowest price possible, while a seller will wantto collect as much purchase price at closing, in cash as it can.  As stated above, gaps in valuation with creative use of various techniques.

Transactions are typically valued using metrics like:

  • Multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) or SDE (seller’s discretionary income)
  • Discounted cash flow
  • Comparables

Often gaps in valuation are bridged using earnouts, or payment of additional purchase price after closing if certain specified benchmarks in revenues or earnings are realized.

The Merger and Acquisition Process

Every M&A transaction plays out differently. However, each one will normally follow a similar course of steps. Below is a representative description of the life of a M&A transaction:

  1. The sell-side team (which can be one or more of brokers, lawyers, and CPAs) perform preliminary review and create a Confidential Information Memorandum (CIM) to provide to potential purchasers.
  2. Interested purchasers provide an Indication of Interest (or “IOI”) and execute a confidentiality agreement (or “NDA”) in order to get access to additional information to allow negotiation and execution of a Letter of Intent.
  3. Once the primary deal terms are agreed in a LOI, the Companies carry out due diligence and negotiate the definitive agreements.
  4. Closing.
  5. Post-closure integration and implementation.

Let Our Business Lawyers Lend a Hand With Mergers and Acquisitions for Small Businesses

This introduction barely begins to scratch the surface of the myriad issues involved in M&A.  It is critical that, as early as possible, anyone considering any involvement in a transaction hire competent advisors, including lawyers and CPA’s with M&A experience, to navigate a transaction more smoothly and efficiently. Protect yourself against tax and liability risks unique to business transactions, and incorporate M&A into your exit strategy and estate planning by calling  us at 919-787-7711 today if you are contemplating or are involved in a M&A transaction.

Update: Court blocks non-compete ban

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In a significant development in the world of non-competes, a federal court has issued a nationwide injunction of the Federal Trade Commission’s (FTC) attempt to implement a nationwide ban on non-compete agreements. The case is Ryan, LLC vs. Federal Trade Commission.

The rule, which was to take effect on September 4, 2024, would have prohibited employers from enforcing non-compete clauses in most cases, affecting an estimated 30 million Americans. However, Judge Ada Brown of the U.S. District Court for the Northern District of Texas ruled that the FTC lacks the statutory authority to enact such a sweeping rule without congressional approval, deeming the rule “arbitrary and capricious.”

This ruling is a major setback for the FTC, which has argued that non-compete agreements restrict workers’ economic mobility and are detrimental to fair competition. Business groups, on the other hand, have contended that these agreements are crucial for protecting business interests, fostering innovation, and ensuring growth. The ruling is part of a broader legal battle involving multiple lawsuits against the FTC’s rule in various states, including Texas (where the nationwide injunction was issued and seems likely to be appealed), Florida (where an injunction was issued but only applied to the plaintiffs in the case), and Pennsylvania (where the court declined to issue an injunction stating the plaintiff had not demonstrated the necessary likelihood of success on its challenge to the ban). 

The implications of this court decision are profound, as it not only halts the immediate implementation of the non-compete ban but also sets the stage for further legal challenges that could potentially nullify the rule entirely. Despite the roll-back of the Chevron doctrine (which for decades gave great deference to agency interpretation) by the Loper Bright decision, FTC is expected to appeal the decision.  The case underscores the ongoing tension between regulatory efforts to protect workers and business interests in the evolving landscape of employment law.

The U.S. Chamber of Commerce President and CEO Suzanne P. Clark stated “This decision is a significant win in the Chamber’s fight against government micromanagement of business decisions. A sweeping prohibition of noncompete agreements by the FTC was an unlawful extension of power that would have put American workers, businesses, and our economy at a competitive disadvantage…We remain committed to holding the FTC — and all agencies — accountable to the rule of law, ensuring American workers and businesses can thrive.”

For now, non-competes remain subject to state specific statutes and case law, and their enforceability is typically highly dependent on the particular facts and circumstances of any given case. If your business relies on non-compete agreements or you’re concerned about how this ongoing legal battle might affect your operations, it’s crucial to stay informed and prepared. At Wilson Ratledge, our team of experienced attorneys is here to help you navigate these complex legal changes and ensure your business remains compliant with the latest regulations. Contact us today to discuss how we can protect your business interests and provide tailored legal strategies to help you succeed.

Two Speakers at 2024 NCIC Conference

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The North Carolina Industrial Commission’s 29th Annual Workers’ Compensation Educational Conference will be held at the Raleigh Convention Center, September 30, 2024 through October 2, 2024. 

We are thrilled to announce that attorneys Kristine L. Prati and Daniel C. Pope, Jr., who are both board certified workers’ compensation specialists, will be presenting at this year’s conference.

Kristine will be speaking before other professionals on “Best Practices for Communicating with Physicians in Workers’ Compensation Cases” and Dan will lead the discussion, “Back to Basics – Injury by Accident“.

Registration for the event is now open.  Visit the North Carolina Industrial Commission website for more details.

Creating a Charitable Legacy: Charitable Remainder Trusts for Business Owners

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You’ve worked hard to build your business into what it is today, and now you’re reaping the rewards. Maybe you’re considering sharing the wealth with a favorite charity or two. One way to do that is by creating a charitable remainder trust.

Charitable remainder trusts offer benefits for your business, your family, and your charity of choice. Read on to discover more about charitable remainder trusts and whether creating one makes sense for you.

What Is a Charitable Remainder Trust?

A charitable remainder trust, also called a CRT, is a type of irrevocable trust that provides income to the trust creator (or settlor) and designated income beneficiary(ies) while they’re still alive. After the death of the last income beneficiary, the assets in the trust go to the designated charity or charities.

Types of Charitable Remainder Trusts

There are two types of charitable remainder trusts:

  • Charitable Remainder Annuity Trust (CRAT): A CRAT provides a fixed payment to the income beneficiary(ies) of the trust every year regardless of the principal in the trust.
  • Charitable Remainder Unitrust (CRUT): With a CRUT, the annual income payment is calculated as a percentage of donated assets. This payment is recalculated annually based on the trust principal value, which has to be determined annually.

Another type of charitable trust is the charitable lead trust. Charitable lead trusts pay charities while the trust creator is alive rather than after their death. The remaining principal is paid to beneficiaries after the trust creator (settlor) dies.  These are outside the scope of this post.

How Do Charitable Remainder Trusts Work?

Here’s the basic gist of how charitable remainder trusts work:

  1. First, you’ll need to create the trust with the help of an estate planning attorney. Note that the trust must be irrevocable (more on what that means below).
  2. Once you’ve created the trust, you’ll transfer assets into it. You can put any type of assets into your trust, but ideally, they should be assets that have appreciated and will continue to appreciate in value over time. Such assets may include real estate, such as commercial or residential rental property, and stocks.
  3. The trustee pays a set sum to the income beneficiary(ies) until the last of them dies. Some trusts only pay for a specific period of time, such as up to 20 years.
  4. The trustee will file annual, fiduciary income tax returns.
  5. When the last income beneficiary dies, the remaining assets in the trust pass to the charity or charities.

Benefits of a Charitable Remainder Trust

One of the biggest perks of charitable remainder trusts is that they can provide a lifetime income stream for you and your designated lifetime beneficiaries..

Another major benefit is that you can prevent your family from having to pay estate taxes on the assets after your death. Once you’ve transferred assets into the trust, they belong to the trust and are no longer a part of your taxable estate; however, you will report the gift and allocate a portion of your lifetime exemption from estate and gift tax to the value of the gift, but your estate will save estate and gift tax on the appreciation in value from the date of the gift to your date of death.

Charitable remainder trusts are an option for creative planning with appreciated assets, achieving a current charitable income tax deduction without recognizing capital gains tax.

Are There Any Drawbacks or Limitations?

The largest drawback of charitable remainder trusts is that they are irrevocable. Irrevocability is a double-edged sword: It can protect your assets from your beneficiaries’ creditors and lower estate taxes, but you will give up significant control of the asset and the trust, which is why experienced legal counsel is critical at the outset.

Charitable remainder trusts, being irrevocable, require their own tax identification number and must file their own tax returns.  Income beneficiaries must report their income payments and pay tax on those payments.

Is a Charitable Remainder Trust Right for You?

As mentioned above, charitable remainder trusts are ideal for business owners who:

  • Have assets that have appreciated and will continue to appreciate
  • Want to make significantcontributions to one or more charities
  • Want to retain a lifetime income stream

Disclaimer: This blog post provides general information and does not constitute legal or tax advice. It is essential to consult with an attorney and tax advisor to determine if a CRT is suitable for your specific circumstances..

Contact an Estate Planning Lawyer To Learn More

Charitable remainder trusts offer impressive benefits, but they’re not right for every business owner. Not sure whether this type of trust makes sense for you? Reach out to Wilson Ratledge PLLC. Our attorneys will go over the perks and limitations of charitable remainder trusts to help you decide.

For a consultation, call Wilson Ratledge PLLC at 919-787-7711.