Before we start this blog, I must point out that, in this story of the merger of Best Blogs Ever, Inc (BBE) and Blog Topics, Inc. (BTI), I assume that both companies pay income taxes. Given that BBE and BTI are small, privately owned businesses, in the real world, they would be organized in such a manner as to avoid double taxation on their earnings (tax on the company's earnings and then tax on the shareholders' dividends). Under US tax rules, they could elect to avoid income taxes at the corporate level, and their owners/shareholders would be directly taxed on the company's earnings. The tax rules give a benefit to small, closely held businesses since one layer of taxes is avoided, i.e., the tax on the entity's income. In order to explain some financial concepts, we will suspend reality on this issue. With this caveat, we return to the story.
When we first met with Bob and Mary Pat, we had exchanged financial information with them. Each side had provided the other with three years of financial statements and tax returns. We have agreed that the merger will be a swap of shares. Therefore, the most important issue is the value of each company's common shares. Since Bob and Mary Pat have agreed to trade their common shares in BTI for a combination of BBE preferred shares and common shares, we need to reach agreement on the values of our respective businesses. Preferred shares have a par value so it is easy to determine how many preferred shares Bob and Mary Pat will receive once agreement on the price for their shares is reached. Since preferred shares have no voting rights, their par value has no impact of the voting structure of BBE. If those shares were to be redeemed, Bob and Mary Pat would receive the stated par value for each share, which also plays a role in establishing the dividend rate.
Since BBE stock is the currency we will spend on the merger, it is important that we decide what each share of our stock is worth. We will propose that the par value of each share of the preferred shares will be $500. The value of the common shares, with no par value, is a different story. Our financial consultant, Mary Jo, has spent quite a bit of time on BBE's financial statements. She tells us that there are three different ways to value a small business: the asset analysis, the income approach and the market comparison method. She reviews each of them as they might apply to our company.
The asset approach involves a review of our balance sheet. In the latest year, BBE's assets, which consist of our servers, computers, office furniture and accounts receivable, total $150,000. BBE owes its bank a total of $35,000 divided between an equipment loan with a balance of $30,000 and a revolving loan with a balance of $5,000. Here is a link to the blog about those loans. The equity in BBE is the difference, $115,000. The equity in BBE includes the $5,000 invested by the original shareholders when the company was formed, the later VFI investment of $70,000 in preferred and common stock plus retained earnings of $40,000. Retained earnings represent the net income earned in the past which was not distributed to the shareholders as dividends. Since the 600 preferred shares issued to VFI with a par value of $100 per share totals $60,000, the remaining equity of $55,000 is shared by the 13,500 issued common shares. This gives each share a book value of $4.07. Mary Jo points out that the book value for the shares does not reflect the true value of the stock. The real assets of BBE are its people, the blog writers whose efforts produce the company's income. In a very real sense, our assets leave the office every night. Although mathematically correct, the asset approach does not present the true value of BBE's common stock.
Analyzing the company's income statements is the second way to look at the company. The value of a company is based, in large part, on the income the shareholders can expect the business to earn over their period of ownership. In the last fiscal year, BBE had gross revenues of $185,000 and expenses of $100,000 for a gross profit of $85,000. After debt service, preferred and common share dividends, depreciation, taxes and other accounting deductions, the net income for the year under GAAP accounting rules was $65,000. If you divide that net income by the 13,500 shares of issued BBE common stock, you arrive at $4.82 earnings per share. A person interested in buying shares in BBE would then have to estimate its future earnings for several years and then calculate the discounted value of that income stream in order to arrive at a "present value" for the shares. Because the result of this mathematical exercise depends heavily on what earnings are projected and the discount rate used in this analysis, the results can vary over a wide range of value. In effect, similar numbers looked at in different ways will produce different values. Although the mathematical formula may be correct, the financial assumptions made will determine either a high or a low value for the stock being studied. Like beauty, value is in the eye of the beholder.
The final method of valuing shares in a private company is market comparison. You can look at publicly traded companies in the same business and see how the stock market values them. One of the easiest metrics to apply is the price/earnings ratio (P/E), which we have discussed in other blogs. Let's assume that there is a publicly owned company which posts blogs just like BBE and BTI, and its shares trade in the market with a P/E of 21. The higher the P/E, the higher the stock value. Since this is a public company, its P/E is higher than one that could be commanded by our small business. Mary Jo tells us that if you apply a lower ratio, such as 15 to BBE's earnings per share of $4.82, the value of a share would be $72.30 ($4.82 x 15). Obviously, Bob and Mary Pat would argue for a higher P/E ratio.
We will return to Mary Jo's analysis and advice in the next blog.
Comments are always welcome.