, CASE 34 L.A. CAFE VALUATION Pat Thompson was stunned by the estimate of his partner, Craig Moore. \"How can a business,\" Thompson asked Moore, \"with sales of less than $800 thou- sand be worth nearly $5 million?\" Moore calmly replied that he had \"merely used a formula recommended by experts\" to obtain the estimate. For nearly twelve years Moore and Thompson have been owners of the L.A. Cafe. The restaurant has always been successful, which is not surprising given Moore's extraordinary culinary talents, Thompson's exceptional administrative expertise, and their prior experience as maitre d's at two leading area restaurants. Until six months ago, their relationship was extremely harmonious; the men were equal partners in both time and money. Recently, however, Moore has been spend~ ing less time at the restaurant and generally seems disinterested in the whole busi ness. Questioned by Thompson, Moore admitted that he has tired of the restaurant and would like to sell his interest, move to New York and work as a maitre d'. Thompson likes the idea of being L A.' s sole owner and asked Moore what he thought LA. was worth. Moore's response of $4.8 million left Thompson shocked, and he became extremely aggravated when Moore refused to divulge the mysterious formula he used to make the estimate \"until the time was right.\" Further discussion lead nowhere until Thompson persuaded Moore to meet with Nathan Rogers, their accountant and nancial advisor for the last five years. Both trusted Rogers and felt he had a good understanding of the restaurant business. THE MEETING WITH ROGERS At their meeting Moore revealed the formula that he had used. He had gone ' to the library and consulted a leading financial textbook where he found the following equation, 226 PART Vll VALUATION D1 was the company's earnings before interest and taxes (EBIT) from the current year ($96,000); g was the yearly growth in EBIT over the past seven years, 10 percent; and 1' was the rate at which he thought money would be bor- rowed, 12 percent. Thompson was quick to point out that the restaurant busi ness is highly competitive and risky; therefore it is unlikely past growth rates can be maintained. As evidence he cited the 4 percent per year growth of the last two years, which is far below the yearly increases during the previous five years. Thompson also asked Moore if he considered the $40,000 aftertax cost of remodeling, or that most area restaurants last about 15 to 20 years before going out of business and that he would have to assume the outstanding debt of the restaurant. Moore admitted he wasn't sure \"the formula has considered all this,\" and then dryly mentioned that he might insist on dividing the restau rant's liquid assets. Rogers also pointed out that both of them have been taking minimum salaries out of the corporation. That is, they have been taking about $25,000 each in salaries (a total of $50,000). But experienced restaurant manage- rial help would be 50 percent more than this. Rogers then attempted to calm an obvi0usly emotional Thompson and soften Moore's firm position by pointing out as tactfully as possible that he is confident the restaurant is worth \"some what less\" than what Moore estimates. \"One rule of thumb,\" Rogers continued, \"that is sometimes used by business brokers in pricing restaurants is fair mar ket value for assets plus 20 percent for a goodwill factor, less the amount of any interest-bearing debt.\" He quickly pointed out, however, that any rule of thumb is at best only an approximation. It can't be expected to apply to a wide range of situations, each involving different conditions and circumstances. "In other words,\" he summed up, \"the restaurant could be worth more or less than this." Finally, he emphasized that there is no magic number of value that \"we are searching for. It is best to think of a range of values; that is, the business is worth between A and B. . . I see my job as trying to narrow that range as much as pos sible.\" After further discussion, Moore and Thompson agreed that more analy sis is called for and asked Rogers for a detailed report. POSTMORTEM After they left, Rogers talked about the case with his partner, Edwin Daugherty, for nearly an hour. Daugherty said it was a good idea for Rogers to have men tioned that there is no magic number for the value of the business. \"This gets them in the right frame of mind for the inevitable bargaining later on. I mean, all we can really do is narrow the discussion to a range of reasonable values. ' Negotiation and personality are likely to determine the final price." Rogers agreed and decided to make estimates under three different scenarios. (See Exhibit 2.) There were a number of points that Daugherty and Rogers agreed were com mon to all three scenarios. CASE 34 L. A. CAFE 2.27 1. An estimate should discount the future yearly after-tax cash flow a buyer can expect to receive. 2. The restaurant's present working capital and equipment situation is adequate. 3. The amount of yearly depreciation will be about equal to the yearly princi pal repayment on the debt. 4. No cash will be necessary to support any future increases in working capital. This occurs because changes in receivables and inventory will be offset by the changes in accounts payable and other current liabilities. 5. Any growth in earnings before taxes (EBT) will be used to purchase or main- tain equipment. NOTE: Assumptions 3, 4, and 5 imply that the aftertax cash ow a buyer will receive each year equals the net income or earnings after taxes (EAT) estimate of each scenario. 7 6. The valuation estimate should consider a competitive wage and the renova- tion cost. 7. The appropriate after-tax discount rate is 20 percent. 8. The relevant tax rate is 35 percent. ' Exhibit 2 presents the assumptions that are specific to each scenario. QUESTIONS 1. Give as many reasons as you can why Moore's initial estimate of the value of the restaurant was inappropriate. 2. Calculate the current liquidation value of the business assuming the assets can be sold at 75 percent of book and all debt is paid off at 100 percent of book. 3. Daugherty and Rogers believe that their valuation estimate should reect cempetitive managerial wages. Do you agree that this adjustment to an EBT (earnings before taxes) estimate should be made? Why or why not? 4. Estimate the value of the restaurant in each of the three scenarios. 5. Using the business brokers' ruie of thumb, estimate the value of the restaurant. _ 6. If Moore insists on dividing up the cash and marketable securities, what would happen to your estimates in question 4? (Assume the restaurant cur- rently has the optimal amount of these assets.) 7. How important are the liquidation value estimates in Exhibit 2 to the analy- sis? Explain. 228 PART VII VALUATION 8. Suppose Moore insists the value of the business is equal to the estimate obtained under \"optimistic\" assumptions. Should Thompson buy the res- taurant? Suppose he feels an identical restaurant could be established for (equity of) $150,000. How would this affect your answer? 9. Suppose Rogers obtains information on three other restaurants that were sold in the last year, and their market to book (MV/BV) ratios were 1, 0.85, and 0.75. How would this information affect the negotiations? SOFTWARE QUESTION 10. Rogers has decided that the valuation estimates need to be redone in View of new information gathered by his partner, Daugherty. First, it now seems that the $40,000 after-tax remodeling estimate is a "lower limit" and could run as high as $65,000. Second, the EBT and liquidation value estimates in Exhibit 2 need to be raised since it appears that the restaurant can be run a bit more efficiently than Rogers initially assumed. Third, Daugherty has convinced Rogers that the appropriate discount rate \"could be as low as 15 percent." After some thought, Daugherty and Rogers have modified the scenarios in Exhibit 2 as follows. Scenario Pessimistic Moderate Optimistic EBT / year $60,000 $65,000 $70,000 Life of business 7 years 10 years 15 years Terminal value $40,000 $60,000 $130,000 Discount rate .21 .18 .15 Remodeling costs $65,000 $50,000 $40,000 Further, Daugherty's research unc0vered information on two other restaurants that sold in the last year (this is in addition to the three men- tioned in question 9). The market to book (MV/BV) ratios were 1.1 and 1.0, respectively. Finally, Rogers wants to estimate the restaurant' 5 current liquidation value "more precisely." He thinks that it is reasonable to assume that receivables can be converted into cash at 80 percent of book value, inventory at 70 percent and buildings / equipment at 60 percent. These gures are all net of any liquidation expenses. He will also assume that all debt is paid off at 100 percent of book value. Redo your answers to questions 2, 4, 5, 8, and 9 in light of this new information. CASE 34 L. A. CAFE 229 EXHIBIT 1 Current Year Balance Sheet and Income Statement 1. Balance Sheet _ Assets liabilities and Equity Cash $46,500 Notes payable $22,500 Accounts receivable 28,500 Accounts payable 34,500 Inventory 24,000 Other current 25,500 Building 8: Bonds 88,500 equipment 186,000 Equity 114,000 Total liabilities and Total assets $285,000 equity ' 285,000 2. Income Statement Sales $765,000 Cost of goods sold 337,500 Operating expenses 331 500 EBIT 96,000 Interest 13,500 Earnings before taxes $82,500 EXHIBIT 2 Assumptions Specific to Each Scenario Pessimistic Moderate E BT $ 7 5,000/yr $82,500/yr $90,000/yr Life of Business 7 10 rs 15 s Liquidation value $40,000 $70,000 $140,000 at and of period (after-tax) Ir