Volume 37, Issue 4, April 2002

MoneyMatters

Calculating Value
by Rick Moreno

What’s your business worth? This is an important question to business owners in the glass industry and it will become more so as you near retirement and think about enjoying the fruits of your labors.

An economist would tell you that your business is worth the price on which you and a willing buyer agree. You cannot, of course, know that price ahead of time, but you can arrive at a good guess if you look at your business through the eyes of a buyer.

Calculating Worth
One method of doing this is to calculate the present value of the future benefits that your buyer will derive from owning your business. In plain terms this means simple arithmetic that focuses on what a buyer might expect to earn from owning your business.

Assume your business generates \$1 million in revenues annually, with \$100,000 in steady profits, year after year. On average, people in the glass business earn about 18 percent on their equity. Thus, the question becomes, “How much capital would I have to invest to earn \$100,000 in profit at an 18-percent rate of return?”

Maybe. Note that in arriving at our answer we devised a fraction with your \$100,000 in profit as the numerator and 18 percent as the denominator. But, what do we mean by profit?

Tax Tactics
In the real world people who own closely held incorporated businesses tend to maximize business expenses so as to minimize corporate income taxes. Thus, they buy or lease cars through the corporation and deduct the costs as business expenses—usually a perfectly legitimate tactic.

They may also deduct country club dues and even the costs of cars driven by family members who may or may not actually work for the corporation—a not-so-perfectly legitimate tactic. Last but not least, they may give big end-of-year bonuses to themselves and other shareholders, including those family members with the cars.

Such tactics reduce the corporation’s taxable income, thus shielding its profit. But the buyer of such a company won’t necessarily follow the same practices, meaning his net income will be your \$100,000 plus the sum of all those expenses, legitimate or not.

Let’s assume that those car and country club expenses come to \$75,000 a year and that the year-end bonuses total another \$250,000. Thus, the real profit is \$425,000 — \$325,000 plus the original \$100,000 in net income.

Now let’s go back to our original calculation of value. Divide \$425,000 by 0.18 and you get nearly \$2.4 million—more than five times our first answer. (Things get even more complicated if your corporate tax returns show deductions for depreciation, amortization and certain other items, all of which should also be added back into net income. Check with your accountant for details.)

Does this mean your buyer will cut you a check for \$2.4 million without quibbling? Of course not. Quibbling is the name of the game when buying and selling a business. Indeed, a tough buyer will resist adding those deductions to your net income, with the result that you may get far less than you want for your business.
If you conclude from this that it’s not always a good idea to load up your corporate tax returns with personal expenses, you’re probably right. It can come back to haunt you when you get ready to enjoy the fruits of your labor.

Look to next month’s column to learn another method of calculating what your business is worth.

Richard S.Moreno, CPA, of Los Angeles, has more than 20 years experience assisting companies in the glass industry with financial matters.

USG