The day will come when you will need to know the value of your business. It
is likely that its value will be significantly less than you would expect,
especially if you don't start making plans now to enhance its value. This
article will review various reasons that businesses need to be appraised,
describe appraisal concepts and highlight some things you can do to enhance the
value of your business.
Reasons To Have Your Business Appraised
There are many reasons that small business owners need to know the value of
their business including the following:
Selling your business - Business are bought and sold for a variety of
reasons including: retirement, death of the owner, health problems, divorce,
family problems or burnout. In fact, burnout is one of the biggest reasons small
businesses are for sale. Owners frequently get frustrated with employee
problems, taxes, government regulations and "irate customers." Knowing the
current market value of your business will provide you with the information
necessary to properly plan the timing of a sale and to negotiate a sale more
quickly at a reasonable price.
Determining value for a buy/sell agreement - If you have partners or
other shareholders in your business, you should have a buy/sell agreement that
covers the four D's of death, disability, divorce and dissolution. It is
important to have the procedures in writing that you are going to use in
determining value for each of these possibilities. Don't specify some Rule of
Thumb or predetermined appraisal method in these agreements, because they will
most likely not be applicable at the time of need. Some agreements call for each
party to select an appraiser and if they can't agree upon a value a third
appraiser is appointed. This can be very expensive and unnecessary. It is far
better to specify in the agreement the qualifications required of an independent
appraiser. They when the need arises, an appraiser is selected who meets the
specified criteria and is acceptable to all the parties. Criteria for selecting
an appraiser will be covered later on in this article.
Litigation issues - Determining economic, damages bankruptcy issues,
resolving shareholder/partner valuation disputes, or material dissolution all
call for a fully documented appraisal report specifying a value that will hold
up in court and meet state and federal guidelines for valuation issues.
Estate planning for gifts or inheritance - When tax planning for your
personal estate or business interests, an appraisal can provide the needed
support for a reasonable valuation that meets the guidelines of the IRS and
other governmental agencies.
Allocation of purchase price among tangible and intangible assets -
Following the purchase of an existing business, allocation of the purchase price
among the various tangible and intangible assets will provide a tax basis for
value in establishing depreciation and amortization expenses.
Appraisals can be a very helpful tool for determining current market value
and providing insightful analysis regarding the status of the business and its
growth potential. I recently completed an appraisal for a sole practitioner who
owned a very profitable oil and gas consulting practice. He was getting up in
age and was considering selling his business; however, he wanted to work for
five more years. His business was growing and there was an immediate need to
bring in another consultant. His plan was to sell a portion of the business to
another practicing consultant who was already providing subcontracting services
for him. This younger man could eventually take over the entire business. Upon
completion of the appraisal, it became apparent that the business was going to
need several additional consultants to handle all the new business being
generated by the founding owner. The analysis of the business showed that it
would be beneficial to bring in several new shareholders who could handle the
expanding business and provide a larger pool of prospective buyers to buy the
founding owners shares when he decided to retire. In all likelihood, the
expanded business would be worth a lot more in five years than it is today
adding significant value to the founding owner's estate.
Valuation Concepts
The concept of value was set forth as early as the first century, B.C., when
Publilius Syrns wrote his Maxim 847: "Everything is worth what its purchaser
will pay for it," or as an early British economist, Samuel Bailey wrote in 1825,
"Value, in its ultimate sense, appears to mean the esteem in which an object is
held." Thus, a closely held business may have a high value to its owner
resulting from the efforts expended to build it, but it may have a much lower
value to a potential buyer who may be more interested in return on investment
than past efforts of the Seller.
A fundamental principle in valuing a business is that each determination of
value must be based on the specific facts presented for the case at hand. This
is reconfirmed in the Internal Revenue Service's Revenue Ruling 59-60 which
states that "A determination of "Fair Market Value", being a question of fact,
will depend upon the circumstances in each case." Thus, a proper valuation of a
business will result from a dispassionate analysis of the firm's objective and
subjective factors such as: the firm's financial condition; future income and
expense risk factors; market and industry considerations; management and
marketing functions; and the perceived esteem with which the business is held by
its owners and or others.
Publilius and Bailey's intuitive precepts regarding the nature of value have
been institutionalized in Revenue Ruling 59-60 where Fair Market Value is
defined as:
"the price at which the property would change hands between a willing Buyer
and a willing Seller when the former is under no compulsion to buy and the
latter is not under any compulsion to sell, both parties having reasonable
knowledge of relevant facts."
The concept of Fair Market Value is by no means as clear-cut as the exactness
of the IRS definition would imply, or as its universal usage would indicate. The
facts of each case always must dictate the firm's actual value as of the date of
valuation. The relevant facts must be uncovered through a vigorous business
appraisal methodology, and then be tempered with sound judgment in arriving at
an opinion of value.
Factors Influencing Value
There are many potential factors that can influence the value of a firm,
however, eight factors have been given preeminence in Revenue Ruling 59-60:
- The nature of the business and the history of the enterprise from its
inception.
- The economic outlook in general and the condition and outlook of the specific
industry in particular.
- The book value of the stock and the financial condition of the business.
- The earnings capacity of the company.
- The dividend-paying capacity.
- Whether or not the enterprise has goodwill or other intangible value.
- Sales of stock and the size of the block of stock to be valued.
- The market price of stocks of corporations engaged in the same or a similar
line of business having their stocks actively traded in a free and open market,
either on an exchange or over-the-counter.
The foremost valuation factor to be considered for an operating company
generally is its earnings capacity. The business must first provide a sufficient
return on the tangible assets required to operate the business, then any excess
earnings is attributable to the intangible assets. From a layman's point of
view, all intangible assets are often referred to as the "Big Pot Theory Of
Goodwill." For an intangible asset to exist from a valuation, accounting and
legal perspective, it must possess two attributes. First, there must be existing
customers, an established business and a specific bundle of legal rights
associated with the existence of any intangible asset. Secondly, the intangible
assets must be able to produce profits sufficient to support the investment.
We recently appraised a 15 year old janitorial supply company wherein the
owner wanted to retire. The company grossed approximately $800,000 which was
down about $200,000 from the prior year. They reported for tax purposes a loss
of approximately $20,000 after paying the owner a salary of $50,000. The
business had assets of equipment and inventory valued at $250,000; however, even
after making some adjustments for some nonrecurring expenses, the business had
very marginal profits. The company did not earn sufficient earnings to support a
reasonable return on the value of the tangible assets let alone any value for
intangible assets. Our final opinion of value was greater than liquidation
value, but less than the market value of the tangible assets. The value of the
business assets had to be discounted to a level wherein the earnings would
support the investment. As you might guess, the owner was very disappointed in
the value outcome. It was his opinion that after 15 years in business his
company should have some goodwill value. While he had an established business,
the intangible assets did not produce any earnings. If the owner is willing to
spend the time and money needed to increase earnings, then perhaps some time in
the future, the business will have value greater than its assets. In this
situation, each business owner must decide for themselves if they want to commit
the time and resources required to improve the business or accept the current
value and move on.
Appraisal Approaches And Methods
An appraisal approach is defined as a general way at determining an
indication of value using one or more appraisal methods. The three approaches
typically used to determine the value of a business are the Asset Based
Approach, Market Approach and the Income Approach.
Asset Based Approach Methods
The Asset Based Approach is defined as a general way of determining total
asset value of the corporation or business. Based upon the selected standard of
value to be used, the appraiser will determine the appraisal methods that
produce indications of value that best represents the nature of the assets being
appraised.
Book Value rarely reflects any standard of market value. For valuation
purposes, the Company's balance sheet most always needs to be restated to
reflect the market value of its assets and liabilities. The methods used for
determining this value for the diverse group of assets owned by the Company
include:
Direct Market Comparison Method - This method compares sales of similar items
of like condition and utility. Used equipment dealers are a good source of this
information. These dealers generally buy used equipment at values close to
liquidation and then resell the items after required repairs typically at values
in the range of 40% to 75% of costs new depending upon condition and market
trends.
Cost Less Depreciation Method - This method starts with Cost New and deducts
value for functional, physical and economic obsolescence factors.
Asset Based Methods provide a base indication of value before any
consideration of the earnings the tangible assets generate. If a business is to
have a value greater than its tangible assets, then the earnings must provide a
return in excess of that needed to support the tangible asset values.
Market Approach Methods
The Market Approach is defined as a general way of determining a value
indication using one or more methods that compare the subject to similar
investments that have been sold. It is a market oriented concept based on the
Principle of Substitution. This Principle assumes that the value of a thing
tends to be determined by the cost of acquiring an equally desirable substitute.
Past transactions can provide objective, empirical data for developing value
measures. Examples of market approach methods include the following:
Ratios of price to gross sales, price to earnings or price to asset value can
be derived from past guideline transactions of public and privately held
companies. These ratios are then applied to the sales, earnings and/or assets of
the company being appraised to derive indications of value.
Rules of thumb may provide insight on the value of a business; however, value
indications derived from the use of rules of thumb should not be given
substantial weight unless supported by other valuation methods. At best, rules
of thumb are based on averages and do not account for a business being below or
above average. Furthermore, rules of thumb typically are unclear as to the
assets and/or liabilities that should be included.
The major difficulty with using Market Approach Methods is finding guideline
companies that are similar to the business being appraised. Public company data
is often not directly comparable with small privately held companies and data
from transactions in private firms is not publicly available. There are several
proprietary databases of private business sale transactions to which business
appraisers can subscribe, however, the data available is very limited.
Income Approach Methods
The income approach is defined as a general way of determining an indication
of value by using one or more methods that convert anticipated benefits into
value. It is a widely recognized approach to estimating economic value. The
income approach considers a business or other income producing property more or
less as though it were a money machine whose purpose is to produce money for its
owner. This approach best encompasses the Principle of Anticipation, wherein
value changes in expectation of some future benefit or detriment affecting the
property. Income Approach Methods involve estimating the amount of future income
and converting the income into an estimate of value.
There are several common income approach methods that can be used to
determine value. For small businesses these include the following:
Multiple of Discretionary Earnings Method - This method derives a level of
earnings known as Discretionary Earnings, described as Adjusted Pretax Earnings
plus depreciation, interest expense and the salary of the owner. These earnings
are converted into a value using a multiplier ranging from 1 to 3 representing
all the risk elements associated with the business as well as the required rate
of return. The derived value encompasses all of the operating assets of the
company. Net working capital and real estate would be additive values.
Excess Earnings Method - This method uses a level of earnings known as
adjusted pretax or after tax earnings. These earnings account for the salary of
a manager to operate the business and economic depreciation. An amount is
deducted from earnings representing the required return needed to support the
tangible asset value. Then if there are any excess earnings, they are
attributable to the intangible assets. The excess earnings are converted into a
value using a capitalization rate representing all the risk associated with the
intangible assets. The value of the tangible assets are added to the derived
value of the intangible assets for a total value of the company.
Capitalization of Earnings Method - This method also uses a level of earnings
known as adjusted pretax or after tax earnings. The earnings are then
capitalized into an indication of value using a capitalization rate representing
all the risk associated with the tangible and intangible assets. The resulting
value includes all of the operating assets of the company including net working
capital. Real estate value would be additive so long as a reasonable rent has
been included in the business' operating expenses.
Discounted Future Benefits Method - When forecasted future earnings can be
reasonably developed, then the Discounted Future Benefits Method is acceptable.
This method utilizes one of several forms of forecasted after tax earnings over
a period of five to 10 years. These earnings are then converted into a value
using a present value concept. This method is more applicable to larger
businesses that have stable or predictable earnings. Most small businesses have
difficulty forecasting their earnings for next month let alone five years or
more.
Buyers tend to put the most emphasis on Income Approach Methods as they are
based on anticipated earnings which capture the required return on the personal
efforts of the buyer as well as the capital being invested.
Indications of value should be considered using appraisal methods from each
of these appraisal approaches, unless the appraiser deems one or more of the
appraisal approaches not appropriate, in which case the reasons for not using an
appraisal approach should be stated in the appraisal report. Within each
approach, there are numerous methods that the appraiser can use to determine
value. However, it is not necessary to explore every known method within each
approach. The appraiser should be familiar with a sufficient number of appraisal
methods within each approach to select those methods that best represent the
type of business being appraised. Revenue Ruling 59-60 states, "no general
formula may be given that is applicable to the many different valuation
situations arising in the valuation of stock . . . and furthermore, no useful
purpose is served by taking an average of several factors and basing the
valuation on the result."
How To enhance The Value Of Your Business...Some Do's
And Don'ts
Owning a business is considered to be part of the American dream; however,
when it comes time to sell your business or have it appraised due to tax or
litigation issues, it can be either a pleasant memory or a horrible nightmare.
Here are some do's and don't that will have an impact on the value of your
business.
Don'ts
Overbuild leasehold improvements (ego gratification) - In appraisal terms,
this is called "over improvement" and adds nothing to the value of the business.
Poor property lease terms - Not having a lease or locking yourself into an
lease with onerous terms detracts from the value of the business. Not having a
lease to assign to a buyer runs the risk that the landlord will increase the
rent for the new owner. If the rent goes up, the earnings go down and
consequently the value of the business goes down. A lease with onerous terms
impacts earnings and business value.
Keep slow moving, outdated and/or excessive inventory. These types of
inventory tie up your money and make the business difficult to sell. Buyers will
refuse to buy or will deeply discount the value associated with these types of
inventory.
Poor financial records - This is one of the biggest reasons businesses do not
sell or sell at a value considerably less than market value. Hire competent
accounting help and keep your financial records current. Report all income. We
all know how to be creative when it comes to expenses, but if the total sales
are not properly reported, earnings can not be verified except through
observation. If a buyer needs to obtain outside financing, financial
institutions are not going to rely on observation. They want to see financial
statements that reflect all of the sales and operating expenses.
Poor housekeeping - Appearance is important to a buyer. Even if customers and
clients do not typically visit the business location, "curb appeal" is still
important. No one likes to work in a pig's pen. A little paint and elbow grease
will go a long way in making a facility presentable.
Wait too long to sell - Owners often wait to put their business on the market
until they are required due to some emergency or unforeseen circumstances. A
growing business is worth more than one that is declining. Retiring owners
frequently let the business retire before they are completely ready to retire
themselves. It can take two years or more to sell a business. Waiting to the
last minute to sell will likely have disastrous results on the business value.
Do's
Get your financial records in order - With good financial records, not only
can you manage your business better, a prospective buyer can quickly determine
the earnings and arrange financing.
Keep up your advertising, promotions and marketing efforts - You want to sell
when the business is still growing to maximize value.
Get an appraisal of the business, equipment and real estate - Knowing the
market value of your assets enables you to properly plan your exit strategy and
greatly enhances a buyer's due diligence process. If you require buyer prospects
to obtain their own appraisals you lose all control over issues of value. He who
has the most facts usually wins.
Get all offers to purchase in writing - Selling a business is a difficult
task. Buyers will often want to start the due diligence period prior to making a
commitment to buy. Then when they do make an offer it may be considerably less
than expected, resulting in a lot of wasted time and money. Some basic
information must be provided up front to entice a buyer to consider the
business; however, due diligence should not start until the deal structure has
been put in writing and preferably along with earnest money in escrow.
Utilize professionals to represent you - Put together a team of professionals
to assist you in selling your business. These will include:
1. A business broker can ad value to your business by providing the following
services: prepare a marketing package that describes the attributes of your
business; confidentially find and screen prospective buyers; provide advice
regarding market trends and the marketability of your business; assist in the
negotiations; coordinate the sale process between all the parties to the
transaction. A business broker's creative transactional skills often makes the
difference in being able to put a deal together.
2. An attorney can review all the legal documents and provide legal advice
that will protect your rights and keep you from having legal problems after the
sale.
3. An accountant can get your financial records in order, help explain the
financial records to the buyer and his advisers, and help you understand the tax
consequences of a sale.
Finding An Appraiser
When the time comes to have your business appraised, here are some tips on
how to find the best appraiser for your business.
Look for an Accredited Appraiser who has designations from a professional
association such as the American Society of Appraisers or the Institute of
Business Appraisers. The designations show that the appraiser has met strict
education and experience requirements and successfully completed several written
examinations to prove his or her appraisal knowledge.
Never choose an appraiser who works for a fixed percentage based on the
amount of value being determined. An ethical and objective appraiser will charge
a flat fee or a hourly fee for the work.
The appraiser should be independent rather than an advocate. Your accountant
and attorney are considered your advocates, but an appraiser should be able to
conduct an appraisal and prepare a report independently of any other
relationships with the business owner. Little if any credence will be
attributable to an appraisal conducted by an advocate.
The appraiser should adhere to the Uniform Standards of Professional
Appraisal Practice (USPAP).
Review the appraiser's qualifications statement or job history resume for his
or her documented accomplishments.
Check the appraiser's references, including recommendations by attorneys,
accountants, banks and financial institutions.
Conduct a personal interview to determine how the appraiser's experience and
knowledge relates to your particular assignment.
