I would like a detailed answer on how to value small IT consulting
firms.  I have been given an opportunity to buy into a small, 17 man
IT consulting firm and would like to know how to value it by standard
valuation methods to come up with a price per percentage point.  Some
pertinents:
- revenue 2002 $3.5 Million, earnings of $170,000 pretax
- revenue 2003 $3.5 Million, earnings on track for about $180-$200K 
- accounts receivable of $600,000
- neglible office equipment

I came up with a sample valuation of a PE of 3 after tax plus dollar
for dollar on the accounts receivable.  Assuming a 30% tax rate, the
sample valuation works out to:
[(0.7 * $200,000 * 3) + $600,000]/100 
=$10,200 per percentage point  

a PE of 2 works out to $8,800 a point.  

The PE is a wild guess on my part, so I am looking for other ways to
value the firm.

Thanks!

---

Request for Question Clarification by answerguru-ga on 11 Sep 2003 21:07 PDT

Hi dogmania,

you are missing a lot of information here that needs to be supplied
before a proper valuation can be conducted. Have you gotten the books
of the firm - the financial statements such as balance sheet, income
statement, and cashflow statement are the most important things you
need. If you cannot post this information here, I urge you to consider
the assets (land/property) that you may have left out as well as any
liabilities (loans, accounts payable). While you may have figures for
earnings that doesn't say much if you are building up debt at the same
time.

I would also look at the monthly income/outflow of cash to make sure
you are in a position to sustain operability.

answerguru-ga

---

Clarification of Question by dogmania-ga on 12 Sep 2003 06:47 PDT

The cash Flow on a monthly basis about $250K-$300K in revenue.  Income
is $10K to $40K per month, depending on revenue.  I have been working
with them for a about a year and the balance sheet looks good.

No debt, makes payroll and throws off some cash most months, no land,
great reputation.

Reputation of a really strong consulting firm with good folks.  I know
that IT consulting firms lost a lot of their premiums, so the owner
should not be expecting a rich valuation as in the dot com heyday.  
Given this, am looking a for a mechanism for valuation in the current
environment.

---

Request for Question Clarification by answerguru-ga on 12 Sep 2003 09:15 PDT

Hi dogmania,

There are a lot of business valuation methods that I'm sure you will
be interested in here:

http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds/ch12.pdf

Since the different methods work on different conceptual frameworks
(or ideals) I thought it would be better if I let you decide which one
is most convincing for your purpose. If any of these do end up solving
your quandry please do let me know and I will perform the calculation
for the valuation method(s) of your choice as the official answer.

Thanks,
answerguru-ga

---

Clarification of Question by dogmania-ga on 12 Sep 2003 13:37 PDT

This is a comment to answerguru.  I am not sure which valuation method
to use so perhaps you could run through a couple of them to calculate
what the firm's valuation would be. As this is a private company, I
assume that premiums or lower than the open market.  With two
different valuations, I can get a sense of the value per point and
consider this answered.
 
Thanks! 
dogmania

Hi dogmania-ga,

As you requested, I've gone ahead and completed the calculations based
on the suggested valuation techniques listed in the link I provided
earlier. Here it is again:

http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds/ch12.pdf

Rather than write out the formulas here, I will just show the
variables that are used in the calculation along with the values I
have set them to - you can see the exact formulas by going to the
appropriate section in the link above. Upon reading the source
material a little more closely, I realized that only one method of
calculation really applied to this type of business (the other one's
are very heavily based on fixed assets and/or were considering public
companies).

Value of Equity:

Obviously the most difficult thing to do here is determine the values
of the variables so I am making my own estimates based on what you
have stated.

Variables:

Life of the company (years) = 25

This was based on the fact that the company is already well
established, experiencing growth, in a growing industry, and has a
good reputation.

Cashflow to Equity (period t) = 119000(1.05)^t

Dealing with after-tax dollars (assuming tax rate of 30%) and growing
at a constant rate of 5% per year yields to given above cashflow. I
know you may feel that it should be higher than 5% but this is a
conservative estimate due to the state of the economy and the
historical volatility of the industry.

Cost of Equity = 4%

What you are losing by not putting your money elsewhere...

Note that I have not considered accounts receivable here since its not
considered equity until it is paid out (limitation of this method).

Given the above numbers, some work in Excel yields the following:

Year	Equity	Cost of Equity	Year Value
1	$119,000	1.04	$114,423
2	$131,198	1.08	$121,299
3	$137,757	1.12	$122,466
4	$144,645	1.17	$123,643
5	$151,878	1.22	$124,832
6	$159,471	1.27	$126,033
7	$167,445	1.32	$127,244
8	$175,817	1.37	$128,468
9	$184,608	1.42	$129,703
10	$193,838	1.48	$130,950
11	$203,530	1.54	$132,209
12	$213,707	1.60	$133,481
13	$224,392	1.67	$134,764
14	$235,612	1.73	$136,060
15	$247,392	1.80	$137,368
16	$259,762	1.87	$138,689
17	$272,750	1.95	$140,023
18	$286,388	2.03	$141,369
19	$300,707	2.11	$142,728
20	$315,742	2.19	$144,101
21	$331,530	2.28	$145,486
22	$348,106	2.37	$146,885
23	$365,511	2.46	$148,298
24	$383,787	2.56	$149,724
25	$402,976	2.67	$151,163

Total Value of Equity (company life) = $3,371,410

This is to say that if you were the full owner of this company, you
could expect to make this amount over the life of the company (in
today's dollars). This is NOT to say that you should pay this amount
if you want to buy out the company (for example) - this is what you
can expect the firm to yield over the years.

As far as the opportunity at hand, it is somewhat standard to value
current ownership at 15-20% of this total value of equity over 25
years (there is a formula to calculate the percentage based upon the
expected life of the company).

So, assume you want 1% ownership in the firm - the range you should
pay will be calculated as follows:

1% of Total Value of Equity (company life) = $33,714

Low-end offer = $33,714*0.15 = $5,057
High-end offer = $33,714*0.20 = $6,742

Now that I look at this, you have a great opportunity here, and the
main reasons for that are:

1. You already know the business and the people - risk is very much
minimized

2. The human capital seems to be happy and secured for a relatively
long period

3. You don't have to fork out for (depreciating) assets like land,
buildings, etc.

Hopefully this has helped you put a price tag on this opportunity by
using a standard valuation technique. Let me know if you have any
problems understanding the information above. All the best in your new
venture :)

Cheers!

answerguru-ga

If you are buying into a people business, the most important assets
are the people and can you be assured of their continued loyalty?

If not, can you hire like-for-like replacements?

The critical questions you must ask yourself is: 'Why are these guys
letting me in?'

Is it because they need me? Or my money? Or what?

Sometimes, when new money moves in, the engine slows down.

You are correct on the People Business side.  We've tied up the A
players with long term contracts.  The other folks are like-for-like
replaceable.

They are letting me in because I have been working with them for the
past year to help stabilize and grow the business.

The New Money is really to allow the owner founder to monetize part of
his investment.

Hi, Dogmania

You seem to be in a VERY advantageous position, having worked in the
business for the past 12 months.

Obviously, the owner likes you and you like him/her.

So, there should be no unpleasant surprises.

Really, it's now all down to your negotiating ability.

He/she has probably quoted you a starting price and, over dinner, you
could say, 'Hey, come on Marty, how much do you really want? This is
not Bill Gates you're talking to you know ...'

Generally, investors get such PATHETIC returns on their passive
investments that you should be absolutely rolling in cash if you can
buy in to an active investment.

You must consider (a) the lousy returns you are presently making on
your so-called 'investments'; and (b) the very low rates at which you
can now borrow provided (as always) that you can demonstrate to the
lender that you don't really need their support, anyway.

Good luck!

(And do let us know how your get on.)

Bryan

This is a comment to answerguru.  I am not sure which valuation method
to use so perhaps you could run through a couple of them to calculate
what the firm's valuation would be. As this is a private company, I
assume that premiums or lower than the open market.  With two
different valuations, I can get a sense of the value per point and
consider this answered.

Thanks!
dogmania