Why your customer list doesn’t matter to a bank.
Why are we in business? To maximize the value of our business … period. In doing so, we create a great place to work, provide job security, create an environment where we provide great service for our customers and do business in a socially responsible manner, such as donating to charity or sponsoring local events.
Most experts in our industry agree that maximizing the value of a landscape business entails creating a book of recurring services. This includes, for example, selling monthly or weekly maintenance contracts or multiple step lawn care contracts.
All informed landscape professionals should know the value of his or her company for the following reasons:
- It’s a good move to do an annual business check-up to determine financial strengths and weaknesses internally and as compared to other companies.
- As part of your retirement and estate planning.
- In case you need to dispute conclusions of IRS audits.
- In case of a merger or acquisition opportunity – no matter if you’re the buyer or seller.
Get feedback. So how much is your company worth? Well, that’s easy. The answer is you value your company as a multiple of revenues.
But, not so fast.
In fact, if you were to sell your company to one of the larger players in the industry, they would perform due diligence and come up with a price, which most of these players predicate on a percentage of revenues based on the outcome of the due diligence. If your objective is to sell your business, the answer is to call one of the players in the market who is making acquisitions and let him give you a value. It will be a percentage of annual revenues with certain adjustments.
However, if you need a valuation for estate planning or you are purchasing another company, you may need financing. Most banks and the SBA will loan at 75-80 percent loan to value of the asset being purchased. This means that you may qualify for a loan of up to 75-80 percent of the value of your business and or the target you intend to purchase. In this case, the value may have to be determined by having a valuation performed by a certified appraisal firm.
In almost all cases, the approaches taken in these types of appraisals will result in a value that is less than what an industry insider would pay. This is due to the fact that the single largest asset is the customer list and those recurring contracts attached to that list. The customer list is an intangible asset and is subject to several valuation approaches, which you can read about in the second section. The insiders in our industry usually are willing to pay a multiple of annual recurring revenue based on the potential profitability of the recurring work.
The numbers behind discounted cash flow
1. Determine the average life of a customer. This can be done by looking at all customers in your database and taking an average for how long they stay on the books as a recurring customer. Beyond this we can drill down and not just determine the average life of all customers, but we can determine the average life of different classes of customers. Perhaps residential customers are six years and commercial ones are seven years.
2. What is the average profit per customer? Here we take a look at annual programs. So for example each residential customer purchases a $500 per year program and each annual commercial contract is $1,500. Let’s say that we make on average 25 percent profit. This would mean that residential customers on average yield $125 per year and commercial customers yield $375 per year. Or after six years (average life) a residential customer will yield $750 and a commercial after seven years (average life) will yield $2,625.
3. If we were to put our money in the bank we could probably earn 2 percent. This 2 percent is almost without risk. Being in business is risky. Therefore we require a much greater return on our money. Let’s assume we require a 15 percent return to make such an investment. This is known as our required rate.
4. If we discount the above (I use a financial calculator):
a. The discounted value of residential contracts that yield $125 cash flow per year at a required rate of return of 15 percent for six years: the value would be $473.
b. The discounted value of commercial contracts that yield $375 cash flow per year at a required rate of return of 15 percent for seven years: the value would be $1,560.
However, you may be in for a rude awakening if you have a professional appraisal performed by a bank’s appraiser. An intangible asset such as a customer list is only as good as the use that can be made of it. In the landscape industry, most in the acquisition game know how to maximize the value of a purchased customer list. Someone sitting outside the industry may not see quite as much value. This may be the reason for the disparity between what the insiders will pay and those outside the industry who try to place values on land care firms.
Most certified appraisers use the valuation framework spelled out in Internal Revenue Service Ruling 59-60. The purpose of this revenue ruling is to outline the approaches, methods and factors to be considered in valuing the stock of closely held corporations for income, estate and gift tax purposes and is the grand daddy of valuation methodology when it comes to valuing closely held companies.
Methods for results. While there are eight broad factors to be considered in the ruling, these factors are used as guidelines only. As mentioned above, the single largest asset in a landscape firm is the customer list, which is intangible. While there is clearly value in equipment, it is usually valued at current market value. The three most widely used valuation techniques for valuing intangibles are:
The cost of creation technique – Using this technique, the appraiser seeks to determine what another business would pay to recreate the customer list in today’s dollars. This method does not consider if the list would contribute to future profit, but rather only considers creation of the asset from scratch.
Capitalization of income method – Using this technique, the appraiser tries to measure the future benefit in monetary terms the customer list will generate. This technique not only includes cash generated but also many types of savings to the company as a result of owning the assets. One of the more obvious savings is making the acquirer more efficient with his routing because he uses the stops purchased as “tuck-ins.”
Discounted cash flow – This is the most popular method of valuing an intangible asset. Using this technique, the average life of various customer relationships is estimated. For example, a commercial customer may have a longer average life than a residential account or vice-versa. Once estimates of those relationship classes have been determined, average annual profit is estimated from each classification. These two factors – annual profit and the time that annual profit is expected to last – determine a discount rate. The discount rate won’t be the current interest rate, but rather it will reflect a risk premium (mostly risk of lower retention). In this manner, the discount rate will usually be significantly higher than the rate at which a landscape professional can borrow. The higher the discount rate, the less the value assigned to the customer list. See the sidebar on pg. 126 for a detailed breakdown of this process.
From a bank’s perspective, hard assets are always more attractive than intangibles. A bank can securitize a building, a skid-steer or a dump truck. While it can file a lien on an intangible asset like a customer list, the collateral is only as good as the list itself. In a default, a bank wants to foreclose and flip the property and be out.
The last thing it wants is to try to sell a customer list or operate the company. A firm that is running into financial trouble is probably having issues maintaining the value of the list. It’s for this reason that banks are not enamored with the service industry and therefore appraisals commissioned by them usually come back lower than an insider might pay who is familiar with the industry.
Conclusion. We should remember that a higher value is desirable in a situation where you are selling your own company in order to maximize wealth. In a purchase situation, the appraisal needs to be close to the purchase price if you are seeking outside financing.
In other words, the bank won’t lend you money to overpay for an acquisition. On the flipside, there are several reasons that a higher valuation is not desirable such as gift and estate planning, as well as marital dissolutions.
In these cases the landscape professional may not be rooting for a high value but rather a lower valuation. In all cases the prudent owner should work with a competent attorney and CPA to meet his objectives, be it purchases, sales, succession planning or just staying informed.
The author is a New Jersey-based CPA. He runs Turfbooks, an accounting firm that serves landscapers. Email him at email@example.com.