May 2024

Summary

Is it possible that a business can have minimal to no loss of net income or cash flow and still lose value? Theoretically—and most likely, practically—the answer to that question is yes.

The following case study examines the veracity and application of one of the most basic formulas used in the valuation of businesses and other intangible assets. The damages case was much more complex and nuanced than presented here. However, the energetic and complex litigation boiled down to a very basic question: Is it possible for a business to lose value even though cash flow generated by the business stayed the same, or increased, after the damage event?

Risky Business

A large, profitable, privately held business was up for sale. The sellers (a small ownership group) had adequately prepared for the process, and their efforts resulted in the submission of several letters of intent, with more expected. The sellers had substantial alternative investment opportunities that were dependent on a well-planned and rapid sale of the subject company, and a lot of work had been done to make the business attractive to strategic buyers. The subject company had a significant presence in a well-defined industry with relatively few competitors and high barriers to entry into the market. The sellers knew the company was attractive to competitors and other synergistic buyers and, therefore, anticipated a smooth due diligence process and a quick closing.

The seller's favored strategic buyer had already submitted an offer, as had the second and third choices. All pending offers were based on the same general formula: 10 times adjusted EBITDA, or more. Several of the potential buyers were granted access to a virtual data room and had visited the business to tour the plant and commence negotiations.

One buyer, in particular, was pressing to close the deal and eventually the other suitors were pushed aside. The formula for calculating adjusted EBITDA and the multiple to be applied to adjusted EBITDA had been negotiated, and both parties agreed. The plan was to complete normal operations the following month, calculate adjusted EBITDA based in part on those operating results, and complete the transaction at the predetermined formula.

The subject company was highly dependent on a single supplier, although there were many available suppliers in the industry. Because it looked like there was going to be a sale of the business, the buyer requested that the sellers contact the supplier to notify it of the sale and to get assurances that there would be no interruption in supply for the new owners. For reasons that are not important for this narrative, once the supplier was informed about the sale, it actively and knowingly sabotaged the sale by immediately cutting off all supply and creating negative publicity throughout the industry and with the company's customers. Because of the potential reputation damage within the industry, the seller was forced to notify potential buyers of the supply interruption. In response, all potential buyers either dropped out of the process or immediately amended their offers for substantially lower amounts.

Meanwhile, the seller was able to replace inventory supply through new vendors within two weeks and allay customers' concerns sufficiently to resume normal sales. But the damage had already been done. After several weeks, the primary buyer reengaged in the process. Inventory supply and cash flow had returned to normal and improved. However, the potential buyer dropped its offer from more than 10 times adjusted EBITDA to less than six times adjusted EBITDA. When the sellers rejected the modified offer, the sales process was terminated.

The sellers sued the supplier to recover the lost value of the business and damages related to interrupting a transaction that caused lost opportunity for the sellers. In short, the claim was that the deliberate and dramatic effort of the supplier to damage the subject business and prevent the sale was successful and damages were, therefore, due to the sellers to compensate for lost value related to the contemplated sale. Ignoring the permanence of the loss for purposes of this analysis, the controversy became whether it is possible that a business can have minimal to no loss of net income or cash flow and still lose value. Theoretically—and, most likely, practically—the answer to that question is yes … of course! The shareholders (potential sellers) thought so.

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Reprinted with permission: "The Value Examiner," A Professional Development Journal for the Consulting Disciplines (April 2024)

Of all the assets that make up an estate, the most complex and valuable is often the closely-held business. The business represents a lifetime of effort and the source of wealth, income, and great satisfaction. The first hurdle in succession planning is to understand what the owner has to pass along. Establishing the nature of the business and the ownership interest is critical to accurately and efficiently implementing a succession plan. Putting a value on that interest is easily the most difficult part of determining "What do I have?"

Hiring the right valuation firm is obviously a crucial decision. Arxis Financial's valuation specialists provide clients with a comprehensible valuation that aids attorneys, business owners, management, and financial planners in succession planning. We also have extensive experience in presenting and defending our findings in the context of litigation. Our clients benefit from having valuation professionals who understand the realities of market valuations, resulting in very defensible valuations. Our experts are well-known in the industry and highly respected for their depth of knowledge and resources.

The Business Valuation practice is headed by partner Chris L. Hamilton, CPA, CFE, CVA. Mr. Hamilton is a Certified Public Accountant, Certified Fraud Examiner, and a Certified Valuation Analyst. He is a licensed life and disability insurance agent and a General Securities Representative. Mr. Hamilton has published articles in several publications, and has made presentations at national conferences, training institutes and seminars on topics including forensic accounting, fraud and business appraisal.

If you have any questions about Business Valuation Services for Succession Planning, please feel free to contact us.

Chris Hamilton's upcoming presentations include:

• "Using Financial Documents to Expose Fraud," San Fernando Valley Estate Planning Council (May 9)
• "Business Valuation Fundamentals, Techniques, and Theory" (2 days), Salt Lake City (May 13-14)
• "Ethics, Morality, and the Law," Ronald Reagan Library (May 31)

If you are interested in asking Mr. Hamilton to speak at your organization's upcoming meeting, please feel free to contact him.