Quick Consultant: Economic Value vs. Business Value

Mary, if it ever comes down to this you can have it all,” I told my wife during a late night phone call. The call was made from halfway across the country where I was consulting with an old friend and fellow printer. Actually, it wasn’t a consulting visit, but rather three grueling days spent onsite as both an observer and an expert witness in what could only be described as a nasty divorce case.

Now, while I don’t know much about divorce, and I hope that I never do, I do know something about printing and I am considered an expert in valuing printing firms. It was in this context that I found myself involved as an expert witness in a divorce proceeding. The client was a long-time friend and, against my better judgment, I agreed to appear on his behalf.

The legal proceedings lasted three days. I was there for two of those days – the first day as an observer – and on the second day I appeared as an expert witness for about two hours. In addition to the two days spent in court, I spent the day prior at my client’s office going over testimony and explaining various valuation methods to the attorney.

I don’t know why, but I had initially expected a fairly small proceeding. Wow, was I nave! Gathered in the conference room during most of those three days were three lawyers, four CPAs, three property appraisers, and three business valuation experts. In total, 14 experts were scheduled to testify in the case.

The one overwhelming fact that stuck with me was the only folks who were going to be winners in these proceedings were the lawyers. With both sides armed with six-inch binders crammed with legal exhibits and depositions, it was apparent that the combined legal and expert witness fees would easily top $100,000 and that probably didn’t count all of the expenses.

The lessons to be learned from this appearance? Most of the financial expenses could have been avoided had the couple, early in their business life, conferred with an accountant or CPA and stipulated a method to be used, then and in the future, to value the business. Such planning should be done in the context of estate planning; something everyone should be doing on a regular basis.

Most couples have an opportunity to spend a few thousand dollars now, or possibly face the prospect of spending $100,000 or more in a trial like the one described above. Unfortunately, very few couples (and that includes general partnerships as well) do this kind of planning, and that is truly unfortunate.

Ironically, I estimated that the total amount of expenses incurred on both sides in this divorce proceeding exceeded the estimated differences in business value placed on the business by each party. Had the parties initially agreed to simply split the difference in estimated business values they could have saved themselves between $50,000 and $75,000 in legal fees – and that is a conservative estimate.


Economic vs. Business Value

During the legal proceedings, the phrase “economic value” was mentioned by one of the witnesses. While I understood completely the context in which it was being used, I don’t think I have ever heard it mentioned in terms of business valuations. Nonetheless, it made perfectly good sense to me.

A business really can be seen to have two values – one is the value that the business has as an ongoing entity to the owners or partners and the second is the value of the business if it is sold to a third party.

Oftentimes, early on in the valuation process, couples are shocked to learn that they cannot combine the total amount of compensation paid to both of them and then use this amount in a formula to determine the value of the business. While Bob and Kathy may each take out $50,000 in salary and another $6,500 each in personal benefits, the total amount of compensation of $113,000 will not be used to establish the fair market selling price of the business.

Although the $113,000 may indeed be considered the economic value of the business being realized by the couple, that is not the same amount that would be used by a seller or appraiser to establish the selling price of the business. (Note: This also applies to partnerships.)

The real amount to be used in a valuation scenario might be closer to $40,000-55,000. Why? Because a good portion of what is seen by the selling couple as economic value must be treated as an ordinary expense by the new owner. Not only will the new owner have to assume the functions of one spouse, he or she must also hire someone to replace the functions and duties of the remaining spouse. The salaries required to pay the new owner as well as to replace the other spouse are considered expenses. They are not part of the profit or excess earnings used to calculate the value of the business.

The only exception to that rule, as Larry Hunt and I note in “Print Shop for Sale”, is if the seller (say, the husband) plans on selling his wife along with the business. Although contemplated by a few, that rarely happens in real life.

Consequently, the difference between the economic value that the business represents to a couple or partnership may be vastly different than the value of the business if it is sold. So much so that many couples or partnerships conclude that it may indeed be better to simply continue running the business, even if it is declining, than to attempt to sell it and, thereby, give up a significant portion of the total benefit stream.


Dismal Findings

In anticipation of my testimony as an expert witness, I conducted a fair amount of research; specifically as it applied to valuations in the printing industry. In “Print Shop for Sale”, Hunt and I discuss a number of valuation approaches ranging from income and market approaches to asset-based and earnings approaches. The one valuation method we strongly oppose is the market approach, which seeks to assign value based upon a comparative analysis to sales of similar companies of similar size.

One of the variations of this approach seeks to value firms based almost solely upon a percent of sales. That is to say that if the average printing business in the $1-2 million annual sales range tends to sell for X% of its annual sales, then “all things being equal,” a similar firm with similar sales ought to sell for the same percent of sales.

Of course, the only problem with the “all things being equal,” approach is that things (specifically profits) are never equal. In fact, they vary dramatically from firm to firm and so does the respective value of those firms.

The biggest problem, even within the business valuation community, is the tendency to extrapolate from the averages and apply these extrapolations back to specific firms. Just because the ratio of selling price to annual sales has averaged 62%, does not mean that Company A should sell for that same percent of sales. You simply cannot work backwards with these types of statistics.

During the course of my court appearance, I prepared an analysis of approximately 38 valuations conducted during the past 18 months or so. As you can see from the attached chart, the valuations placed on firms varied dramatically not only in raw dollars but as a percent of sales as well.

It is important to note that, while not all 34 of the companies valued were actually put up for sale, a large majority were. Of those companies listed for sale in the past 18 months, to the best of my knowledge, only three actually sold. Two other firms have letters of intent pending, but a lot can happen between the signing of such a letter and an actual sale.


Writing a Column

Month after month, year after year, I put off writing my column until the last moment; not having the faintest idea what I will write about or where the material will come from. I worry, too, whether I will have enough to fill a column. And then suddenly, out of the blue, I receive an email or a phone call or I get involved with a valuation or a court trial such as the one mentioned above and I find myself wishing I had a hundred pages with which to work, rather than just two.

I wonder what will happen in the next 30 days before my September column is due?