Valuing Small Business
What is your business worth?
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.
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'ts that will have an impact on the value of your business.
- 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 a 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.
- 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 make 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 an 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.
About the author
Jeff Jones is nationally recognized as an experienced business appraiser and business broker and has earned senior level professional designations from national associations representing the appraisal and brokerage industry.
As President of Certified Appraisers, Inc., he manages the firm's multidiscipline appraisal practice, which includes valuation of businesses, machinery & equipment and real estate. As chairman of Certified Business Brokers, he and his staff of 18 agents have been involved in over 1,000 business sales since 1976. Jeff has written many articles on the subject of appraising and selling businesses. He is the co-editor of the "Handbook of Business Valuation" and "Merger and Acquisition Handbook for Small and Midsize Companies".
He is licensed by the Texas Real Estate Commission and the Texas Securities Board. He is a designated member of the American Society of Appraisers (ASA); the Institute of Business Appraisers (CBA); Texas Association of Business Brokers (BCB); and the International Business Brokers Association (FCBI).