SEC 7 AVERAGE OF FACTORS

Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors and the end result cannot be supported by a realistic application of the significant facts in the case except by means of chance.

But when appraiser uses subjective weighting, one usually wants to know how much weight is accorded to the various techniques. So, the appraisers usually apply mathematical weights when giving weight to two or more approaches, with a disclaimer that there is no empirical basis for assigning mathematical weights, and that the weights are presented only to help clarifying the thought process of the analyst. A good report will also go on to demonstrate that all relevant factors are considered while deciding the weights.

“Statement on standards for valuation services” issued by the American Institute of Certified Professional Accountants (AICPA) consulting services executive committee also provides for consideration of more than one approach while deriving a conclusion of value. Para 42 of the statement is produced below:

“Conclusion of Value

64 a. Correlate and reconcile the results obtained under the different approaches and methods used.

b. Assess the reliability of the results under the different approaches and methods using the information gathered during the valuation engagement.

c. Determine, based on items a and b, whether the conclusion of value should reflect (1) the results of one valuation approach and method or (2) a combination of the results of more than one valuation approach and method.”

IPEV guidelines (October, 2006) also permits usage of more than one technique to arrive at the fair value of investment. It narrates that

”…..Where the valuer considers that several methodologies are appropriate to value a specific investment, the valuer may consider the outcome of these different valuation methodologies so that the results of one particular method may be used as a cross-check of values or to corroborate or otherwise be used in conjunction with one or more other methodologies in order to determine the Fair value of Investment”.

So, we can conclude that the conclusive value rests on COMMON SENSE AND REASONABLENESS. The important factor in any valuation is that the method used is relevant to your purpose of valuation, your type of business, providing a valid and supportable value. This wide variety of methods available can be a confusing array to choose from. There are plenty of pros and cons for each method. While there is no such thing as absolute truth in business valuation, confidence in the eventual number is based on the integrity of the underlying process. To assure that integrity, many valuation professionals use more than one method, computing a weighted average to arrive at their final number. While there are numerous valuation methodologies that can be utilized to begin establishing value, not all methodologies would be appropriate for all situations. Each methodology provides additional clarity on valuation and evaluating results of numerous methods provides a better understanding of a business’ true “worth”. A fair amount of experience, judgment and corporate finance and equity markets skill is required in each case as even the seemingly straightforward tools contain several hidden layers of complexity and subtle ties.

‘‘ The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a

technique of thinking, which helps its possessor to draw correct conclusions.’’

John Maynard Keynes

65 Seller will try to maximize the value of the company by applying a forward-looking valuation methodology - such as the Discounted Cash Flow Technique ("DCF"). It is an opportunity cost of seller which he will loose upon selling the business. The DCF accounts for the going-concern value of the company as indicated by the present value of the company's projected cash flows for a determined maturity period of from 3 to 5 years. As this valuation method pegs the company's value on the growth of future markets - the valuation will generally be high based on the potential for the targeted market.

Unlike the Seller, the Buyer will try to avoid pegging valuation on future markets or on the Seller's plans. Rather, the Buyer will minimize value by looking at the maturity of Seller, the risks inherent in operating the Seller's business, and the additional investment the Buyer will have to make in company in order to tap the targeted market. Essentially, the Buyer will tell the Seller what he or she is willing to pay - based on its subjective view of the attractiveness of the asset or business or company, and what it thinks other competitors might pay if they were also to pursue the Seller.

This does not mean that the Seller should not value its business on DCF. Instead, the Seller should base its price on DCF - and question the Buyer on its assumptions in setting its price. This might have the effect of raising the price, if the Seller can objectively argue value that the Buyer can verify to its satisfaction. The seller may want to increase the total transaction price by proposing that separate consideration be paid for other items of value to the Buyer, such as lock-ups, non-competition, non-employment, employment and consulting fees, break up fees etc. But these will be in addition to the value of “business” proposed for sale.

Not all appraisers will agree, but some do so without knowing they do, that the

small-company appraisal process begins with evaluating human behavior through the

antics of their buyers and sellers. Not nearly true for publicly held business evaluations. This represents the first of many issues that the business appraiser must resolve during the process of estimating closely held business value.

Prospect Theory is an important contribution to the psychological aspect of risk and decision- taking. Developed by psychologists Daniel Kahneman and Amos Tversky, Prospect Theory examines the ways that people are affected by their emotions and also make intellectual errors when making choices. Much depends on how the problem is depicted. For example, lung cancer patients at a certain hospital had a shorter life expectancy if they received radiation therapy than if they opted for surgery, but a few patients died on the operating table. The overall difference in life expectancy was not great and it was difficult to choose which therapy to accept. When patients were presented with the options in terms of the risk of death under surgery, nearly half opted for radiation therapy. Patients who were given the same choice expressed in terms of life expectancy, only a fifth chose radiation therapy. No facts were hidden: they were simply presented in a different light.

66 BUSINESS VALUATION and MSMEs

What is MSME business?

MSME business stands for business run by Micro, Small, and Medium Enterprises. Practically, it is a general term and difficult to define. In India, it is defined as follow: Manufacturing Sector

Manufacturing sector refers to enterprises engaged in manufacture or production, processing or preservation of goods. Please refer First Schedule to the Industries (Development and Regulation) Act, 1951 for the list of eligible industries engaged in the manufacturing sector. The definition of Micro, Small and Medium Enterprises under the manufacturing sector is as below:

i. A micro enterprise is an enterprise where investment in plant and machinery [original cost excluding land and building and the items specified by the Ministry of Small Scale Industries vide its notification No. S.O. 1722(E) dated October 5, 2006] does not exceed Rs. 25 lakh;

ii. A small enterprise is an enterprise where the investment in plant and machinery [original cost excluding land and building and the items specified by the Ministry of Small Scale Industries vide its notification No. S.O. 1722(E) dated October 5, 2006] is more than Rs.25 lakh but does not exceed Rs.5 crore; and

iii. A medium enterprise is an enterprise where the investment in plant and machinery (original cost excluding land and building and the items specified by the Ministry of Small Scale Industries vide its notification No. S.O. 1722(E) dated October 5, 2006) is more than Rs.5 crore but does not exceed Rs.10 crore.

Services Sector

Services sector refers to enterprises engaged in providing or rendering of services. These will include small road & water transport operators (owning a fleet of vehicles not exceeding ten vehicles), small business (whose original cost price of the equipment used for the purpose of business does not exceed Rs.20 lakh) and professional & self employed persons (whose borrowing limits do not exceed Rs.10 lakh of which not more than Rs.2 lakh should be for working capital requirements except in case of professionally qualified medical practitioners setting up of practice in semi-urban and rural areas, the borrowing limits should not exceed Rs.15 lakh with a sub-ceiling of Rs.3 lakh for working capital requirements). The definition of Micro, Small and Medium Enterprises under the services sector is as below:

i. A micro enterprise is an enterprise where the investment in equipment does not exceed Rs.10 lakh;

67 ii. A small enterprise is an enterprise where the investment in equipment is more than Rs.10 lakh but does not exceed Rs.2 crore; and

iii. A medium enterprise is an enterprise where the investment in equipment is more than Rs.2 crore but does not exceed Rs.5 crore.

So, it constitutes Manufacturing sector and Service sector units. The definition is restricted to investment / borrowings only. And a medium sized business unit may have its activities spread in many regions or with numbers of franchisees. It may have branches abroad. I am going to analyze the definition. But our question for Business valuation is, is there any need to separate the relatively small businesses from other large businesses? Whether investment criteria is enough or sufficient to allot an identity of MSME, to any business or unit? What are the factors which differentiate the relevant small business from large businesses?

Business Valuation and MSMEs

In general, there can not be any strict definition for a business to regard as a small or medium or large or giant. It is matter of debate to fix a basis for treatment of business as a small or large. The definition of MSME varies from country to country and from mind to mind. In our case, for business valuation, the important thing is to know whether the fundamentals of valuation changes when applied for business unit which are relatively small in size. My answer is “NO”. The fundamentals of

68 valuation like Premises of value, Standards of value, valuation approaches techniques remains unchanged irrespective of size and identity. But yes, the difficulties to be faced and the considerations require by an appraiser changes due to some inherent characteristics of relatively small businesses. In includes availability and reliability of financial data and other information, quantifying the size risk and business specific risk, size of discount for lack of marketability and lack of control, if any, influence of client, etc. Here, I have considered the businesses (1) which are relatively small and medium in size, in general and (2) functioning of which are controlled by the owners, themselves. And referred these businesses as “MSME” businesses throughout this study. Of course, the need of valuation differs in case of MSMEs when compared to large of public Companies.

Characteristics of MSME

Some of the major characteristics observed are as follows: Ownership

MSME businesses usually are owned by individuals, family members, friends or relatives, and are likely to be highly dependent on the owner/manager. Small businesses often have a high degree of reliance on one or more key owner/managers. In extreme cases, the business may rely on a single person for sales, technical expertise, and/or personal contacts and may not be able to survive without that person. Professional middle managers are a luxury that small businesses seldom can afford. To be profitable, small businesses must operate with a very thin management group. In addition, leaders of small businesses frequently are entrepreneurs who are not comfortable with delegation of management duties to others and may not work well with middle managers. Small companies are apt to have a board of directors composed of insiders- members of the owner’s family and/or employees. Thus they lack the diverse expertise and perspective which otherwise outsiders can bring to a board of directors.

Financial records

Small businesses tend to have lower-quality financial statements that are less likely to have been prepared by a professional accountant or qualified auditor. Their statements tend to be tax oriented rather than oriented to stockholder disclosure as in larger companies.

Whereas large companies usually keep separate records for the preparation of tax returns and generally accepted accounting principles for financial statements, small businesses that have no outside owners have no reason to go to the expense of maintaining separate records for tax and book purposes. Thus, their financial statements tend to reflect a bias toward minimizing income and taxes.

Access to Capital

Small businesses have less access to capital than larger companies and often must rely on capital infusions from the owner family, friends and/or owner employees. Access to debt capital is also more limited because of the higher risk of smaller businesses. The cost of borrowing is higher, and the owner usually must personally guarantee debt. Many small businesses operate with little or no debt, reflecting their limited access to debt capital and a frequent reluctance of owners to take on the risk

69 of substantial debt. Many small business owners minimize debt to reduce risk during economic downturns and to increase the probability of keeping the business in the family.

Other Operational Characteristics

Small businesses can lack diversity in products, markets, and geographic location. Frequently they are very dependent on a few key customers, as when a small manufacturing company primarily produces parts for a single automobile manufacturer. They also may be dependent on a key supplier, as when a manufacturer’s key raw material is a by-product of a single large local manufacturer. Small businesses may have difficulty competing for employees. They may not be able to offer competitive benefit packages and may be in less desirable locations. Good managers may perceive less opportunity for promotions because of the company’s small size and the owning family’s dominance on top management positions. Small businesses can be less informed about their market and competition. They are seldom in a position to pay for sophisticated market studies. Knowledge of markets and competition must come from the experience of a relatively limited number of managers—quite often the experience of a single person. Trade associations supplement this personal knowledge of the market. Thus small businesses operating in industries in which the trade associations are strong may be at less of a disadvantage. In small companies, the portfolio of operations or products frequently reflects the interests and contacts of a particular owner. Sometimes these operations or products have few synergies, and the portfolio may have little appeal to potential buyers.

The characteristics of small businesses tend normally to result in overall higher risk than is found in larger businesses. These characteristics tend to be extreme in the smallest of small businesses. So in general, we can say that “Risk tends to increase as size decreases”.

Summary Differences between Public Companies and MSMEs (as they relate to business value)

1. The obligated task of management in the publicly traded company is to

maximize bottom-line profits, whereas the elective task in the MSME is to minimize profits that can be taxed. The closely held Companies or small enterprises runs for own as oppose to public companies which run for profit or better returns to shareholders. MSME unit generally run by owners themselves and they have direct control over workings and performance of the business. Practically, the returns (even negative returns) under small enterprises go on the hands of owners only irrespective whether financials are reflecting the facts or not. The owner’s goal is to maximize own profit whether separable from business or not. Under showing profits to save tax is a very good example.

2. Stockholders of the publicly traded company are principally investors in the

stock market rather than the company itself; Under MSME, owners ‘‘bet’’ their own

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3. Although company performance influences stock market performance of the public company’s trade prices, individual stockholders tend to have little or no direct

control in how the company runs. Owners of MSME, generally have all controls in how

the business runs, because individuals are quite regularly one and the same as management.

4. Stocks of the public company can fall separately under the influence of supply and demand, interwoven with other company stock offerings, and broadly influenced by general market economies—perhaps, involving many issues that are unrelated to a specific company’s performance. MSME have virtually no stock market value and serve only the interests and wishes of the investor(s) in the business assets. Not their shares but the value of businesses themselves is subjected more to industry and local market economies.

An Overview of the Task of Estimating Values in Small Companies

Business value depends on the effective employment of capital, manpower, machine, and material to produce profits; therefore, ‘‘business’’ value depends on the skills that vary widely among individuals. In cases of closely held businesses, the concept for values must be carried out to include tangible assets, intangible assets, and

perception .So, we can conclude that perceptions of value in MSME are individually swayed and factually weighted by productivity of assets employed. In other words, each

component of business value, including any reference to facts, might change through the personal perceptions of individual calling for valuation. This requires us to examine the following: (a) general market conditions; (b) specific business conditions; and (c) individual perceptions.

Professional service organizations, such as those for physicians, lawyers, accountants, consultants, and so on, are among the more difficult types of businesses for which to establish an intangible value. Practitioner characteristics, personalities, and reputation play heavily into the generation of cash streams. Take the specific practitioner out of the business, and the cash stream will quite often suffer considerably. Therefore, a fundamental question is: How much business value is directly attributable to a ‘‘person,’’ and how much of that value will remain if he or she leaves? To the unwary, this can present the classic dilemma of ‘‘getting lost in