13 Factors You Need to Know About the Valuation of Your Business

Understanding business valuation methods benefits you and your business in many ways.  That it provides you with a value for your business is important and obvious. Everyone wants to know the value of their business.  But thinking about valuation early and often proves valuable over time.  Understanding the value of your business every step of the way and what impacts that value makes for good management. Valuing a closely held business can be challenging.  Public companies can be fairly easy to value as a liquid market exists to determine share price and total market capitalization.  For your closely held, privately owned business, there is a variety of methods used to value your business.  As we will see, the lack of marketability of a closely held business can impact the valuation.

While a business lawyer is not in the practice of business valuations, the valuation of your business matters to you and lawyers for planning purposes, from business formation and structuring to tax planning to developing strategies related to the purchase and sale of the business (M&A structures), to name just a few.  As a result, business lawyers become, or should become, quite familiar in business valuation methods. 

Of course, the goal of your business is to continually grow the value of the business.  As the owner of a closely held business, you will also benefit from an understanding of business valuation methods and the factors that influence your valuation.  As you manage your business, this understanding can lead to actions that increase the value of the business, as well as how to avoid what may diminish the value of the business.  Whether you plan to sell now or in 2020 or have a long term plan to grow your business, understanding the basics of business valuation arms you with valuable knowledge to optimize the management of your business and its future growth and value.

There are five valuation methods to touch on here, with a sixth that is really a hybrid of two others.  The most often used valuation method for privately held business entities is the fair market value (“FMV”).  Fair market value is defined generally as the price at which a business would transfer ownership to another between a willing purchaser and a willing seller when the purchaser is not under any compulsion to purchase and the seller is not under any compulsion to sell and each party to the transaction possesses a reasonable knowledge of the material and relevant facts about the business.  The factors that impact the FMV method informs business managers with respect to factors to consider when establishing your business value or when making management decisions with future value in mind.  While the FMV does not use a specific mathematical formula, there are eight factors to be assessed when determining the fair market value of a business, now or for future valuations.  Your eight factors to be considered are:

  1. The nature of the business and its history since formation.
  2. The future economic outlook generally and the future economic outlook for the specific industry in which the business operates
  3. The book value of the issued shares
  4. The financial condition of the business
  5. The amount of debt or leverage the business maintains
  6. The potential earnings capacity and growth potential
  7. The potential for dividends
  8. An assessment of the goodwill of the company
  9. An assessment of the value of the intellectual property of the company
  10. The liquidity and transferability of the stock in the company
  11. The length of the terms of revenue generating contracts and an assessment of the market value of those services relative to the contract terms.
  12. The length of the terms of the vendor contracts and assessment of the market value for those services.
  13. The degree of management control and who maintains that control

As you can surmise from the list, while the FMV method is most common and has been around a long time, the method necessarily contains subjective analysis that can lead to fairly routine disputes.  The ease and history of disputes suggests two important concepts to bear in mind.  First, your operating agreement or shareholder agreement should contain a provision to secure a professional appraiser for valuations.  A professional appraiser is well equipped to make these judgement calls and back them up with evidence and experience.  Second, it is in everyone’s best interest to hire the best appraiser available.  Often, disputes can be minimized, and substantial money may be saved, by hiring a business appraiser whose quality, reputation, and competence as an appraiser is well known in the community. 

As noted earlier, the valuation of public and private companies is very different.  A public company’s value is substantially determined by demand for its stock, which demand can be influenced by general market conditions and other factors unrelated to the specific performance of the business, such as political influence, global unrest, and short-term pressure from earnings expectations of analysts.  A closely held company tends to be valued with a more direct correlation with the company’s success and factors impacting the specific industry.

Another important consideration to understand in evaluation business value is the value of a minority interest and the lack of marketability of a minority interest in a privately held business.  Generally, a minority interest is an interest that is less than that required to allow a member or shareholder to control and influence the decisions of the Company.  A minority interest in a closely held business may materially restrict the shareholder’s or member’s ability to influence the management of the company.  There are many ways in which minority interests are protected under Florida statutes, but a majority interest often controls the management and day to day operations and the big decisions of the company.  This lack of control, coupled with a limited market for the closely held business ownership interest, effectively reduces the value of a minority interest versus a majority interest.  To account for this control discrepancy, business valuation methods have a mechanism to discount these interests, sometimes by as much as 30-40%.  This discount can have important implications for business planning and structuring.

    There are several other alternative valuation methods to touch on with a quick summary.  First is the book value method.  This method measures the business value on the company’s balance sheet by comparing total assets versus total liabilities.  This method does not consider market value or good will as a going concern.  The simplicity of this method makes it typically a poor measure of value.  To increase the accuracy of the book value method, the adjusted book value method was developed.  This method is the book value method but it adjusts the assets to fair market values.  This method is best when the company’s assets are the key to the company’s value, but not as good for an operating business with future earnings and goodwill that should be included in a measure of value.  Next, is a hybrid method that combines the adjusted book value with another method, the capitalized earnings method.  The capitalized earnings method uses gross multipliers and capitalization rates to calculate a price based on a predetermined capitalization rate.  A capitalization rate measures the net operating income relative to the current market value of the company’s assets.  This calculation is sometimes calculated as an income multiplier.  Ultimately, the hybrid method measures the income relative to the asset values of the company (FMV or adjusted FMV) based upon a standard capitalization rate or income multiplier (Gross Multiplier or Capitalization Rate) to achieve a value or purchase price. A fifth method is called the excess earnings method.  This method is the hybrid method but factors in the cost of carrying the company’s assets and the impact of company financing. This method takes into account the cost of money in the valuation and is a more accurate valuation for highly leveraged business entities.  The last method to touch on is the discounted cash flow of future earnings method. This method considers the anticipated future value of the company. This method projects increasing earnings at a specific rate for a certain period of time. A discount rate is then applied to reflect the amount of risk and uncertainty in the company’s future operations, as well as for the time value of money. This method is often used as a way to confirm the accuracy or conclusions of another method.

There you have it.  A quick summary of things to consider when thinking about the value of your business.  Understanding these concepts will aid you in managing your business and will also lead to you be much better at negotiating for your business.  Often, business negotiations come down to value, such as loan negotiations or early round financing with investors.  Your ability to advocate for the value of your business by discussing the factors above in a favorable way and using the above to compare your business to other businesses will improve your business negotiations. Understanding these factors and alternative valuation methods will also assist you in the process of working with a professional valuation expert, both in valuing your business and valuing other business that you may seek to acquire.

6 Books with 6 Big Leadership Ideas

This morning I came across an Articles by Marcel Schwantes, founder and CEO of Leadership from the Core, on CNBC.  Marcel points out 11 books he considers the best of the decade in leaders, success, and professional growth.  As a lawyer representing primarily entrepreneurs and small business owners, I have the pleasure of working with people that strive to be leaders in their companies and in their industry markets.  The way clients lead their companies is evolving and becoming more empowering and enlightened.  The digital renaissance with rapid innovation in technology promises to transform business in many ways.  Employees and customers expect more.  Today, I break from legal issues and highlight powerful ideas in 6 of the 11 books.  I encourage you to check out Marcel’s articles for the full list.  The 6 books and concepts are:

1. ‘Humble Inquiry: The Gentle Art of Asking Instead of Telling’ by Edgar H. Schein.  Author points out the value in asking questions and learning what you do not know.  Leaders can build powerful relationships with people through genuine curiosity and interest in the ideas of your employees, clients, and others.  Ask, and you shall receive.

2. ‘Nine Lies About Work: A Freethinking Leader’s Guide to the Real World’ by Marcus Buckingham and Ashley Goodall.   If you take one idea from this book to transform your leadership ability, understand that your employees and clients do not want constant feedback, but they respond powerfully to helpful attention.  Leaders empower people with helpful attention.

3. ‘Delivering Happiness: A Path to Profits, Passion, and Purpose’ by Tony Hsieh.  Creating an unconventional business culture that focus on happiness of others and quality of life leads to a more satisfied life.  This leads to abundance.  This all begins with finding your own, unselfish happiness that allows you to empower those around you with the same.  Find your positive passion and empower others to find and discover theirs within your organization.

4. ‘Applied Empathy: The New Language of Leadership’ by Michael Ventura.  This book teaches the power of empathy and applying empathy is powerful leadership.  The more we can understand what drives others, the more we can guide them along their path.  Consider what matters to your employees and clients and empower them to find their unique way.  This is empowering leadership.

5. ‘Switch: How to Change Things When Change Is Hard’ by Chip Heath and Dan Heath.  This book offers insight into effective pivoting as a small business and entrepreneur.  The ability to adjust to actual business conditions can make the difference in your success.  Understanding change is of great importance as your business emerges in all phases.

6. ‘The Art of Being Unreasonable: Lessons in Unconventional Thinking’ by Eli Broad.  This book points out how reasonable can stifle innovation and get us stuck.  Be willing to think about why something new can be done and come up with innovative solutions or improvements.  Such innovation leads to success.  This powerful idea leads innovation.  Remember, innovative ideas are often initially considered unreasonable. 

Marcel’s full article and list of 11 books can be found here:  https://www.cnbc.com/2019/11/22/best-books-of-the-decade-according-to-successful-ceo-and-founder.html

7 Signs of a Ponzi Scheme, Tokenized or Not

Many unscrupulous people target seniors and other trusting people for scams and frauds.  In recent years, the emergence of cryptocurrencies and digital tokens, has had its fair share of scams and frauds.  It is not surprising that with tokenization, follows tokenized scams and frauds.  These signs of a ponzi scheme apply to any ponzi scheme, including the tokenized ponzi scheme. 

While many understandably become frustrated with the regulatory framework in the United States for its broad reach and the complex structure that has evolved over the last 86 years, the Securities and Exchange Commission (“SEC”) plays a key role in targeting and weeding out fraud.  The broadness of its application arises from the myriad of creative fraudsters over the years that devise remarkably clever schemes to defraud.  The tokenization of fraud is no different.

Because the SEC has limited resources, the statutory scheme of our securities laws allows for private actions to be taken by investors, which means plaintiff’s lawyers play a significant role in weeding out fraudulent security offerings.  The private right of action is necessary to assist in the policing of fraud in the markets.  Today, this role is critical to healthy cryptocurrency markets and much continues to be done in this respect. 

But fraud is not new to securities or business law, as the securities laws have been around since the 1930’s and frauds and scams of all shapes and sizes have emerged and existed ever since the enactment of these laws and regulations.  One thing seems clear thus far.  Blockchain and the technology emerging from cryptocurrency is not yet changing the behavior of fraudsters and scammers, though it may prove helpful in providing a new means to introduce reliable evidence in the prosecution of those who wish to defraud the public and record such fraud on blockchains.  One can hope.

Ponzi schemes are older than the Securities Act.  Ponzi schemes are investment frauds that pay existing investors with funds collected from new investors.  Ponzi scheme operators often promise to invest with high returns and little risk.  Often, the money is not invested or only some portion of the money is invested.  Rather than invest it, the new money is used to pay earlier investors, while the promotors keep a portion for themselves.

In reality, a ponzi scheme often creates little or no return and relies on a constant flow of new money to maintain itself.  As investors dry up or investors choose to withdraw their investment, the scheme eventually collapses.  The last one in loses and often loses big.

One of the first ponzi schemes was run in the 1920’s and involved speculation on postage stamps. That scheme was run by Charles Ponzi.

Ponzi schemes tend to have common characteristics and these characteristics serve as warning signs as you are approached by potential investment promotors.  Here are seven things to watch for:

  1. High returns with little or no risk.  Returns have a direct correlation to risk in the investment world.  The more risk, the higher the return.  The less risk, the less return in relative terms.  When a promoter of an investment reverses this, beware.  Be very aware.
  2. Overly consistent returns.  Real investments fluctuate in the marketplace.  There is a natural up and down to any market, due to temporary inefficient market theories (FUD and FOMO come to mind) and the technical ebb and flow of markets.  Be very skeptical of a promotor that suggests you will generate positive returns in any market or regardless of overall market conditions. 
  3. Unregistered Investment.  Scammers and fraudsters rarely register with regulatory agencies, such as the SEC or state securities agencies.   The registration process is a path to access to information about the company and the investment.  Be cautious of unregistered security offerings, which would nearly always be limited to accredited investors. Even then, filings with the SEC are often necessary.
  4. Unlicensed Sellers. The sale of securities to the general public requires investment professionals and firms to be registered or licensed as Investment Advisors or Investment Companies.  Most ponzi schemes are run by unlicensed individuals or companies.
  5. Secretive or complex strategies.  If you are not able to fully understand an investment or it is unnecessarily complicated, it is wise to avoid such investment.  A promoter of an investment should be able to explain an investment and provide you a clear and easy to understand presentation of how the investment works.  Again, be cautious of overly complicated schemes. 
  6. Inadequate or lacking paperwork.  As you review the documents provided, if you see errors or missing information, that may be a sign that things are not as they appear.  If an investment is not well documented or contains inconsistencies, that may be purposeful, and you should use caution. 
  7. Difficulty with payments.  As you experience any delays or attempts to get you to not withdraw funds, that is another red flag.  Delays can indicate fund shortages and an objection to your withdrawing funds suggests the same concern.  Be wary if payments are not made timely upon request.  As you review an investment, look for unusual conditions or delays when you choose to make a withdrawal.  This is the best time to catch that, before you invest funds.

With these 7 warning signs, hopefully you will discover a scam before you invest.  Of course, before you invest is the best time to avoid a ponzi scheme or other fraudulent investment. The warning signs can signal other issues with an investment other than a ponzi scheme as well. All of these warning signs can be applicable in avoiding any scheme to defraud you, the investor.  Over the last several years in the cryptocurrency space, DLT’s lawyers have come across all of the above more than once.  More often than not, the warning signs prove valid.

If you do fall for a scam, keep in mind that the SEC has limited resources and, while suspected scams should be reported to the SEC, you also have a private right of action and can take action in a civil case.

Fraud has a detrimental effect on how markets run and operate.  As the tokenization of assets proliferates, the community can expect new scams and frauds to continue to emerge.  While the SEC works to police the markets and ensures a more efficient and safe market environment for investors, diligent, educated investors can go a long way in assisting in weeding out this activity that hurts the entire market.  As noted, a private right of action also plays a role when an investor falls victim to a cunning scheme, despite being diligent and prudent with investment decisions.  The tokenization of financial markets is not likely to avoid or overcome those willing to defraud investors, but hopefully it can assist us all in revealing the schemes sooner than later. 

LLC Operating Agreements: 15 Reasons You Need One Today

Over half of million LLC’s were formed in Florida in just the last two years.[1]  Many small business owners file a simple set of online Articles of Organization on Sunbiz.org with the Florida Secretary of State’s office to form an LLC.  The Articles have minimal information about the LLC.  The ease at which LLC’s may be formed in Florida, and other states, saves money for small business startups looking to bootstrap their startup companies. For many reasons, LLC’s is often the entity of choice for most small businesses. Most states, including Florida, do not require an LLC to have an operating agreement and many small businesses are simply too tempted to skip this step to save costs in the early formation of the business.   

The number of LLC’s with operating agreements skillfully drafted to account for the specific needs of their business is not readily available, but experience suggests it is likely to be dreadfully low.  Many small businesses either go without an operating agreement or use an operating agreement that is inadequate or generic without considering important issues related to the specific needs of the business and without taking advantage of the flexibility afforded to the LLC entity structure.  Not only do many small businesses miss out on all of the benefits of a skillfully drafted LLC operating agreement, but almost without fail, the lack of an operating agreement leads to later surprises and necessary complications down the road.  While no operating agreement can foresee all possible issues that may arise, much of what has been problematic in the past, can be identified and addressed. Too often, the parties to an LLC are forced into costly negotiations and sometimes even costly litigation to resolve issues that could have been addressed early on with an operating agreement.  Careful attention to the operating agreement in the formation stage benefits the members as the business grows and unexpected events and successes are realized. 

Beginning in January of 2014, the Florida Revised Limited Liability Company Act (the “Revised LLC Act”) became effective for all new LLC’s filed in Florida.  The Revised LLC Act is Chapter 605 of the Florida Statues, replacing the old Chapter 608, which was repealed.[2]  An LLC’s operating agreement guides the LLC in its operation and has many important roles. 

Absent an operating agreement in Florida, members of an LLC and its managers or managing member are subject to the provisions of the Revised LLC Act. While the statute is a default course of action that provides some guidance, allowing for the governance of your LLC by the standard default provisions of the statute may lead to unexpected and undesirable outcomes.  One of the key beneficial principles of an LLC is the enormous amount of flexibility provided by the statutory scheme for the formation and operation of an LLC.

Let’s take a look and highlight 15 important roles of the operating agreement for you as a small business owner, which will help you better understand your operating agreement or illustrate the importance of getting a well drafted operating agreement in place.  Here we go, an operating agreement will:

  1. Specify who will manage the LLC and how it will be managed.  An LLC may be manager-managed or member-managed.  In a member-managed LLC, each member has apparent authority to bind the company.  Care should be taken to determine how to best structure the management of the LLC and how to distributed control of the LLC. A manager in a manager-managed LLC may be a member but need not be a member. An LLC may have one or more managers.
  2. Specify the authority of the management, the scope of actions delegated to the management, and the voting requirements to take action among the management.
  3. Specify how much money or other valuable consideration each Member contributes (or did contribute) to the LLC at the startup and how much may be expected in the future.  This provision may also specify when and under what conditions, and with what approval of the members, whether majority, super majority, or unanimous, additional funding will be provided by each member. The operating agreement also addresses what happens if a member is unable to contribute future capital.
  4. Determine how important decisions will be made by the members and how the management and members will deal with deadlocks in voting.
  5. Provide for how the LLC will deal with the unfortunate circumstance of a member being unable to continue as a member through disability, insanity, incompetence, termination, or death.
  6. Provide the process for which a member may sell their interest in the LLC to a third party.
  7. Provides for a procedure for when a member wants to buy out the interest of another member
  8. Specify the tax classification and the tax matters partner, if applicable
  9. Specify the management of the member’s capital accounts, as applicable (partnership tax provisions in an LLC operating agreement are important).
  10. Provides for a process if the members of the LLC desire to separate, including the dissolution of the LLC.
  11. Determines whether the members are permitted to participate in or start businesses that compete with the LLC’s business
  12. Determines whether one member can force another member to sell their membership interest to a third party that offers to acquire the LLC
  13. Determines how profits will be allocated among the members and who decides how much will be distributed. Same with losses. An LLC taxed as a partnership allows for flexibility in this respect.
  14. Establishes a procedure for determining the value of each membership interest.
  15. Determines what happens in the case of a member filing for bankruptcy.

The Florida Revised LLC Act has 17 matters that may not be waived in an operating agreement.  Other than those 17 matters, a business and its owners may structure their LLC to optimize the management and structure of the LLC as well as plan for future events and how to handle them.

Hopefully this leaves you, the LLC manager or member, with a better understanding of operating agreement and why you should take time to consider the issues that can be customized within an operating agreement and take steps to ensure a customized framework to guide your LLC as your business grows.

[1] In 2017, 263,545 new limited liability companies (“LLC’s”) were formed in Florida.  In 2018, 295,966 new LLC’s were formed in the Florida. see https://dos.myflorida.com/sunbiz/about-us/yearly-statistics/

[2] Note to readers:  A major comprehensive revision to the Corporations Act under Chapter 607 of the Florida Statutes was signed into law in April 2019 and will go into effect January 1, 2020.

Risky Business: How You May Inadvertently Form a General Partnership

You and a few of your friends decide to start a business together. You figured you would just give it a shot and see if you could make some money together with your new idea.  Before long, you begin to realize some success in the market and you and your friends begin making money.  Customers increasing flow to your business.  Cool, right?  You and are your friends are making money. 

One day, one of your partner friends is out personally delivering products to a new customer.  On her way, she decides to meet an old friend for lunch.  As they have not seen each other in a long time, they decide to have a few drinks and toast their old friendship.  After a long lunch, your partner friend continues on her way to deliver products to the new customer.  Sadly, on her way, your business friend slams into another vehicle; totaling the other vehicle and causing severe injuries to the driver and the driver’s passenger.  You friend is charged with a DUI and further charges are pending, as the driver and passenger lie in intensive care. 

Your business partner friend was uninsured.  Weeks go by and one day you are served with a civil lawsuit.  You are named in a wrongful death suit related to your partners accident. You are named individually, along with your friend, and an unknown general partnership, as defendants.  The lawsuit alleges you and your friends were operating a business as a general partnership and you and your friends are all both jointly and severally liable.  The lawsuit alleges your DUI partner friend was working at the time of the accident and, through the legal doctrine of vicarious liability, the partnership is liable for the damage.  The lawsuit lists you, individually, as a partner, and maintains that you and each of your friends are personally, jointly and severally liable for the damages cause by your DUI partner.  While you and your friends often casually referred to each other as partners and you loosely considered yourself business partners, you are confused by the claim you are a partner in a general partnership.   You never formed a general partnership.  There is no partnership agreement.  Even more confusing is how you may be personally liable for your partners actions.

In Florida and most, if not all states, it is possible to unknowing and inadvertently form a general partnership.  With this comes joint and several liability for the partnership and joint and several liability for you, individually, as a partner.  Let me explain.

When two or more people collaborate together for the purpose of making a profit, courts have found such arrangements to qualify as general partnerships.  That’s it.  It is that easy to form a general partnership.  Courts do not require you to have an intent to form a partnership.  As a result, many people unknowingly establish general partnerships in generally the same way as in the example above.  Sometimes, it just happens.  There are many reasons why you do not want to let that just happen.  One is personal liability for the partnerships actions.

Florida has a number of business entity choices, all of which have forms of limited liability protection.  In fact, even a general partnership in Florida can be provided limited liability, but action must be taken by the partners to establish limited liability for the general partnership.  As noted, one thing each of the other business entities have in common, unlike the general partnership, is limited liability.  The substantive advantage of each of these legal entities over a general partnership is that the limited liability acts to shield management and ownership of business entities from individual liability for the actions of the business entity. For this good reason, general partnerships without limited liability are almost non-existent.  General partnerships generally exist only through lack of business planning and general partnerships should never be inadvertently created or purposely created.

Generally, vicarious liability holds another liable for the actions of another.  In an employment context, vicarious liability holds employers liable for employee actions while the employee is at work performing the job.  In effect, this doctrine can also extend to partners in a general partnership acting for the partnership.  Couple this with the joint and several liability of a general partnership, and you and your partners, as individuals, may put all of your personal assets at risk if you or your partner cause harm to others that gives rise to liability.  Joint and several liability means a plaintiff can hold both partners liable (jointly) or may hold just one of the partners entirely liable (severally).  When one partner is held severally liable, that severally liable partner may be burdened with the entire amount of the judgement against the partnership and its partners.  That severally liable partner would then have to pursue the other partners for their share of the liability.  This risk is what gave rise to the concept of limited liability.

Corporations were the first entity to have limited liability for its officers, directors, employees, and shareholders.  The public policy reason for limited liability was to encourage business pursuits by minimizing the risk to individuals starting businesses by limiting the liability to just assets, contributions, and revenues of the business entity only.  This protection later gave rise to limited partnership and limited liability companies.  With all the limited liability entities emerging, Florida then created limited liability for general partnerships, in the form of limited liability partnerships.   This allowed for general partnerships to be formed with limited liability.  If you think you may have inadvertently formed a general partnership, you may be able to either convert the general partnership into an LLC taxed as partnership or file to make your general partnership a limited liability partnership.  With proper planning, most businesses can establish limited liability.  Without it, a general partnership can be an inadvertent trap for the unwary.