.net barcode sdk Valuation Approaches: How We Value a Business in Software

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CHAPTER 2 Valuation Approaches: How We Value a Business
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full-time Victor Snakeman was the moneyman, so they were 75-25 percent shareholders in an S corporation11 After 10 years, Leonardo was taking home about $130,000 a year, plus he was due a substantial amount of profit sharing that was to be distributed when there was plenty of money Leonardo was on top of the world at least as viewed from Australia Then he walked into work one day, and Snakeman fired him, changed the locks, and booted him out They spent two years in lawsuits Leonardo lost The judge said it was legal for Snakeman to fire him His reason for doing so was that income was down and that he couldn t afford Leonardo Interestingly, the year after Leonardo was fired was the best year the company ever had, with net income of $1 million To add insult to injury, Snakeman paid out cash dividends of $5000 probably the minimum amount necessary to make it look like he was not blatantly trying to wreak his revenge on Leonardo, since there was still other litigation pending In the meantime, Leonardo owed taxes of $25,000 on the net income Snakeman was sitting pretty His salary covered his living needs and his taxes, so he was able to make the corporation show the maximum net income possible, generating the maximum possible tax liability for Leonardo, who had $5000 to pay $25,000 of income taxes Obviously, Leonardo was not sitting pretty He was facing imminent bankruptcy, due to a combination of the taxes, litigation costs, and his other living expenses Leonardo was eventually compelled to make an unfavorable deal to stave off bankruptcy He received far less for his stock than the Fair Market Value, which I had calculated on his behalf Of course, that transaction was not taking place at FMV, since the definition of Fair Market Value says that the buyer and seller are acting
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11 An S corporation is taxed primarily like a partnership There is no corporate tax The net income flows through to the shareholders, who are responsible for personal taxes
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PART ONE Business Valuation
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at arm s length That implies that the buyer is not pummeling the seller with brass knuckles while his henchman has him locked in a half nelson12 This story illustrates two principles The first principle and the one we re concerned with in this chapter is that cash is king13 If the company had been a C corporation instead, Leonardo only would have been responsible for personal income taxes on dividends paid to him Then he would have been fine, even though the C corporation arguably would be worth less than the S corporation to the collective ownership, because of corporate taxes14 Or, if Victor Snakeman were a nicer guy, Leonardo never would have been dispelled of his illusion that he was on top of the world It should be obvious, from this story, that cash flow is more important than net income It turns out that net income is the most important component of cash flow, and it is the starting point in our calculation of cash flow The reverse is not true Cash flow is not a component of net income What s less obvious from the story, but no less important, is that in extreme circumstances, net income in the absence of cash flow actually can be harmful to a business owner
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MORE ON DISCOUNTED CASH FLOW
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The advantages to the DCF method are straightforward Logically, investors should be willing to pay more for a business with higher expected cash flows than one with lower expected cash flows, all other things being equal Also, investors should be willing to pay more for a business with less risk associated with achieving the forecast cash flows compared to a firm with the same expected cash flows but with higher risk In general terms, performing a DCF involves the following four steps:
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12 Where was Willie when we needed him Probably singing, Suddenly, I m not half the man I used to be, with apologies to the Beatles 13 This story illustrates a second principle, which comes later in the book, and that is the need for a discount for lack of control, aka, the minority interest discount 14 This is a source of considerable controversy in the valuation profession and will be the subject of research for years to come
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