Creator: Matthew Furtsch is a business valuation analyst with BerryDunn
BY: TIM CANALE
The Principles of Conservatism in Action
Most business owners understand the industry in which they operate and tend to be good at running the day-to-day operations. Yet, that does not mean they have made optimal decisions or that they have the necessary controls and financials in place that enable them to make sound financial decisions. Companies that do not keep high quality data will likely have a lower value. This article focuses on the data problems with the valuation of a sawmill that I recently completed; minor facts and circumstances have been altered to preserve client anonymity.
Company Problems
The company was a multi-generational family-owned business with poor data integrity. The bookkeeping was done in QuickBooks by a family member who had no background in accounting. Records were recorded on a cash basis; as logs were purchased, they were immediately expensed, regardless of when they were sawed into lumber and sold. The result was that the company did not have financial insight into inventory levels or profitability throughout the year. No attempts were made to track inventory other than a year-end inventory count and subsequent true up to cost of goods sold. The sawmill recently experienced a massive flood which resulted in the destruction and replacement of many fixed assets, yet their fixed asset listing did not report any of these new assets. The company employed an outside accountant to assist with bookkeeping. However, he too was a poor source of financial data as he was difficult for management to get a hold of.
Lack of Data Begs Conservative Valuation Assumptions
In the valuation process, a business valuation analyst will endeavor to discover the true value of a business through appropriate adjustments and discount rates. Yet, when a subject company’s books are too haphazard, the practice is to make conservative assumptions in the absence of definitive data. In other words, you do not get credit unless you can prove it. The lack of financial metrics means that owners may not get full credit for the value of the company. This principle popped up several times in the sawmill valuation. The sawmill’s balance sheet showed record of “notes to shareholders.” When management was asked about these notes, they were unable to provide a definitive explanation. Their best guess was that these notes represented money put into the company by the late family matriarch and that the money would not be paid back. Apparently, the matriarch used to oversee the books and put money into the company without telling anyone. Management asked us to speak with their accountant, but again, we could not get a hold of him. Unable to definitively ascertain the meaning of these notes, we were forced to take them at face value and treat them as debt. If the notes were truly not due to be paid back, we would have adjusted them off the balance sheet, improving the equity position. However, we could not in good faith remove the liability.
Another data issue was with their inventory tracking; without year-end financials finished, and no internal records of inventory, there was a massive hole in the balance sheet. This gap in inventory made up about one-third of the company’s value. Since the inventory was such a large portion of the company’s value, we reconciled it. In most valuations, there are often small details that add up, and while preventable, these are time consuming to fix. We proceeded to ask management to physically go out to the lumber yard and count the number of board feet that they had of each dimension and species. While this was an improvement from the initial data, it is still tricky to substantiate in the future. Properly appraising inventory was time-consuming on our part and therefore management spent more time and money on the valuation. Additionally, management did not have any records of equipment purchases since their insurance claim and so, conservative assumptions were made. These judgment calls negatively affected the asset approach. All these factors also led us to consider data quality issues as a company specific risk factor, which increased the discount rate and thus reduced the company’s valuation. As valuators, it is our job to make reasonable adjustments to financial statements, but we are not scoped to do a massive overhaul of the general ledger. When clients straighten out their data prior to a valuation, that allows them to get full credit for their work.
Valuation Scrutiny from Buyers
It is not just valuators that care about messy books, but also potential buyers. It is in a buyer’s best interest to look for any way to punish value. The business is less marketable when the books are in disarray. With the messy books that were highlighted earlier, a potential (hypothetical) buyer would have a harder time ascertaining the value of what they are purchasing and will likely underbid as a result. Or they can spend the resources to establish a more definitive value, but these increased transactions cost would likely be recouped through a lower bid. Even if a buyer could ascertain a reasonable value for the company, to operate efficiently they would need to spend a significant amount of money on accounting fees to get the financial picture straightened out. That would make the buyer less willing to pay. To help a company avoid these pitfalls while selling, the best practice is to help them find a proper accountant. A potential buyer needs to know what is being purchasing. Without a current documented record of inventory, the buyer must go with their ‘gut’ and eyeball what is on the lot, or trust management’s representations regarding value. From a transaction perspective, this is an unexpected level of uncertainty and will likely result in the buyer wanting to purchase the company at a discount. Increased transaction costs for a buyer will either kill the deal or mean the buyer requires a lower price. For our clients that are planning on selling in the future, we discuss Value Acceleration with them. This not only includes trimming the fat to make the business more valuable, but also doing their books right for at least five years before sale.
Poor Operational Decision-Making
In this family-run business, none of the family members had the expertise to effectively track or analyze operational data. That is the case across most closely held businesses; and there also tends to be high emotions entangled, especially during a transaction. If we want to help them run more efficiently, it is a fine line to walk. I have noticed that business owners often want us to be the bad guy for their siblings and coworkers. Tracking operational data would allow the company to operate more efficiently, increase margins and therefore EBITDA, and other key metrics that we use for valuation. Without current record of the inventory that they had on the lot, this sawmill often milled board sizes that they already had in inventory and were not selling. The sawmill then needed to remill these boards to smaller sizes. Not only did the repeat process waste runtime on the saws, but it also resulted in approximately 15% downfall in inventory that would not have occurred had they milled the appropriate size board the first time. As experts in the sawmill space, we can guide them on operational decisions, such as milling demanded boards. Using cash basis accounting meant that they did not know how much money they were making on any given log or truckload of logs and could not make informed decisions about future purchasing quantities or species. Additionally, without knowing the KPIs on their milling process, the mill was not able to make adequate decisions on capital projects. We have expertise with purchases such as an optical scanner, a machine that can help determine the most effective way to mill a log. An additional example related to the sawmill was a large project to create a sawdust bagging facility, in which considerable funds were invested, all to be scrapped halfway through because management’s focuses changed. Better capital planning would have saved them significant funds and helped with profitability. Without tracking supplier quality and quantity, it is hard to determine the appropriate inventory balance given the current price of logs.
Conclusion
As a cautionary tale to business owners, cutting corners on data tracking and management may save a few dollars today but can have drastic impacts on valuation later. As valuators, we often see businesses who have fallen into this pitfall. After a valuation engagement is completed and when it is appropriate, we at Sunbelt Business Advisors, will point our clients towards our value acceleration services where we work closely with a business over three to five years to help them prepare for a more valuable exit opportunity. This process can entail connecting them with our Outsourced Accounting Group, helping them adjust working capital levels to meet the industry, developing processes to track inventory, and many other services as they are needed by a particular client.
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Tim Canale – Senior Mergers & Acquisitions Advisor
DIRECT NUMBER: 702-829-6254
EMAIL: tcanale@sunbeltlv.com
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