VALUATION DISPARITIES

Business brokers, business owners, and business appraisers often value the business differently.  Business owners, in many cases, are biased in their views towards the firm, and therefore, have an inflated sense of value associated with the business.  They value the business simply in terms of what dollar amount they want to realize from a transaction.  Business brokers have a vested interest in maximizing the transaction value in order to maximize their fee potential.  Their value estimate may differ substantially from the actual fair market value that could be realized in an arms length transaction between a willing buyer and a willing seller.  Their value for the business may be based on a rule of thumb or an arbitrary multiple applicable to a measure of cash flow.  In the absence of a valuation of the company by an independent third party, qualified business appraiser, the owners of a small business and the business brokers often have nothing other than a gut feeling or the broker’s calculation of value to support the price for the business.  It’s worth nothing that only a qualified business appraiser with one of the main business appraisal credentials has the qualifications to determine the fair market value of a business for purposes such as SBA loan guarantees.  The disparity between the value placed on the business by the owner, the value by the business broker and the value by the business appraiser may have an impact upon the ability of any borrower to obtain an SBA guaranteed loan.  An inflated value by the business owner or business broker may prevent an SBA guaranteed loan from being obtained and substantially reduce the potential return for a purchaser.  This may, in turn, negatively impact the ability of a business owner to sell the business.

Business appraisers have many methods to value a business.  Usually the final value estimate is determined after considering a number of approaches and methodologies, for example, an income approach and a market approach.  An income approach may utilize a single period capitalization method or a multi-period discounted earnings method, both of which require the calculation of some measure of expected future cash flow.  A market approach may use the direct market data method that applies a multiple derived from a statistically significant sample of transaction data to the company’s earnings or revenues.  Business brokers, however, typically apply a multiple to the seller’s discretionary earnings.  The multiple may range between one and three times seller’s discretionary earnings.  However, the misapplication or misinterpretation of seller’s discretionary earnings can significantly impact the value estimate and the potential success of the transaction.

Case Study

An example is perhaps the best way to illustrate this problem.  Let’s say that the owner of Jacqueline’s Fine Clothing & Accessories is looking to sell the business.  In preparation, Jacqueline hires a certified business appraiser to conduct a valuation of the business.  The specifics of the company are as follows:

  • Revenues=$750,000
  • Net Income After Tax=$75,000
  • Owner’s Salary=$55,000
  • Owner’s Discretionary Expenses=$25,000
  • Interest=$10,000
  • Depreciation & Amortization=$5,000
  • Taxes=$40,000
  • Inventory=$350,000
  • Combined Federal & State Income Tax Rate=40%

In valuing the business, the appraiser uses the single period capitalization method under the income approach and the direct market data method under the market approach.  In using the single period capitalization method, the appraiser develops a forecast of net cash flow to invested capital, calculated according to the following formula:

Net Cash Flow to Invested Capital =

Earnings Before Interest & Taxes X (1-Tax Rate)

+ Depreciation

+ Deferred Taxes

– Capital Expenditures

– Changes in Net Working Capita’

To arrive at the net cash flow to invested capital, the business appraiser first takes net income after tax and adds back interest, taxes, and the owner’s discretionary expenses (such as automobile expense, personal meals and entertainment, etc.), then tax affects this figure.  Adding back depreciation and adjusting for capital expenditures and changes in working capital, the appraiser determines that the expected future net cash flow to invested capital is approximately $85,000.  Once the appraiser has developed the weighted average cost of capital of approximately 19% and the estimated long-term growth rate of 4%, he can then determine the capitalization rate by subtracting the long-term growth rate from the weighted average cost of capital, yielding 15%.  Dividing the $85,000 net cash flow to invested capital by the capitalization rate produces an indication of value of roughly $567,000.  The appraiser then determines the appropriate marketability discount applicable is 20%.  This produces a value indication of roughly $450,000.

The business appraiser then searches the IBA Transaction Database and determines that the median price to sales multiple for transactions of similar businesses is .65.  Based on the company’s risk profile and financial performance, the appraiser determines this is an appropriate multiple applicable to the company.  Applying this produces a value estimate of $488,000.  After adjusting for cash, accounts receivable, and accounts payable, the value estimate is roughly $510,000.  No marketability discount is applicable to this method.

Reconciling these two methods, the business appraiser develops a final indication of enterprise value (total invested capital) of $500,000.  In essence, the business appraiser’s value is for the entire asset side of the balance sheet, including all current assets, inventory, fixed assets, and goodwill.  The following table provides a breakdown of this.

sba2

In essence, a buyer paying $500,000 would expect the transaction to include all of the current assets (including inventory) and fixed assets as well as any intangibles associated with goodwill, customer lists, etc.  Asset sale transactions typically don’t involve transferring cash and accounts receivable, so the actual transactional consideration would be less than the $500,000 valuation.

Jacqueline was pleased with the valuation provided by the certified business appraiser and decided to list her business with a local business broker.  At their initial meeting, Jacqueline brought along her financial statements and tax returns to review with the business broker.  The business broker indicated that he would price the business at three times seller’s discretionary cash flow plus inventory and fixed assets.  The business broker’s calculations are illustrated in the following table:

sba3

Jacqueline is even more excited by the prospects of selling the business for nearly $1.1 million based on the broker’s expectations and estimated listing price.  Jacqueline doesn’t mention the valuation that she had prepared by the certified business appraiser.  In the year after listing the business, several parties expressed interest in buying the business.  One made an offer of $550,000 but all the others were turned off by the asking price.  Unsatisfied, Jacqueline calls the business appraiser to discuss the listing price that had been developed by the broker and to find out why there is such a disparity between the appraiser’s value and the broker’s value.

The business appraiser explains to Jacqueline what exactly would typically be included in the value estimate arrived in his report.  Examining the business broker’s value estimate and calculations, the business appraiser informs Jacqueline that there have been several errors.

First, the business broker has added back the owner’s salary without making an adjustment for the new owner’s expected salary as would be appropriate.  Under the income approach, the management compensation is adjusted to a fair market rate.  Someone must be compensated to manage the operations of the business.  The financial buyer can chose to compensate a manager to oversee the operation or can do the job himself and pay himself the salary for doing so.  In either case, this is a legitimate expense associated with running the business.  If the owner chooses to assume the role of management, they must be compensated in order to earn a living; otherwise, the individual would be working for free, in essence.  The correct way to apply the seller’s discretionary earnings multiple would be to add back the owner’s discretionary expenses and current compensation then subtract a fair market value rate of compensation for an owner or manager.  In this case, including the owner’s salary in discretionary earnings inflates the value by roughly $165,000 ($55,000 x 3.0).

Second, the business broker adds back inventory and fixed assets to the value estimate arrived after applying the multiple to seller’s discretionary earnings.  Doing so implies that the multiple applicable to seller’s discretionary earnings produces a value for the goodwill of the business only.  In this example, the goodwill of the business would have an implied value of $630,000, which is significantly higher than the entire enterprise value of the business as determined by the appraiser ($500,000).  The value estimate should include the normal level of assets necessary to operate the business.  Otherwise, a buyer could simply go out and start the business from scratch by purchasing inventory, fixed assets, etc. for less than the purchase price and value attributed to goodwill for the company.

The appraiser goes on to show Jacqueline why this is the case.  Assuming that a buyer would be willing to pay $1.1 million for the business but would need to finance the acquisition under normal terms offered by a lending institution (20% down, finance roughly $880,000, 7 year amortization, 8% interest rate), the annual principal and interest payments would total roughly $165,000.  This is more than the total EBITDA of $130,000 plus seller’s discretionary expenses of $25,000.  Thus, assuming there is a manager in place that is not the owner, the new owner would be required to put up money out of pocket to fund the annual deficit in operations.  This results in a negative return on equity and does not provide the new owner the opportunity to run personal expenses through the business.  (A business broker, however, might suggest that the owner finance part of the acquisition at a favourable interest rate and that the loan be interest only for a period while also amortized over a longer period of time or that the buyer come up with more cash down in order to make the purchase cash flow.  A buyer’s willingness to do this is predicated upon their risk tolerance and their expectations for return on their investment.)  The prospective acquirer would be better served investing the money in Treasury bond or bills (or a diversified portfolio) that would pay a positive return on the investment.

The correct application of the data by the broker would have produced the following value estimate.

sba4

As can be seen in the preceding table, the correct application of the data and the method would produce a value that is roughly in line with that produced by the business appraiser.  Obviously, the seller would like to maximize the return on their investment by negotiating the highest possible selling price.  This would, of course, also please the business broker who is compensated based upon the transaction price.  However, in most cases the likelihood of successfully negotiating a transaction is highly reduced as the differential between the asking price and the fair market value increases.  Business owners and brokers would do well to remember the following adage from a wise and successful businessman:  Pigs get fat, hogs get slaughtered.

Someone may, indeed, be willing to purchase the business a price between the value conclusion of the business appraiser and the listing price of the business broker.  However, for any value above the business appraiser’s valuation, a buyer would be unlikely to secure SBA guaranteed loan financing, since the financing would be a function of the value of the tangible assets and goodwill (as determined by the business appraiser).  The preceding case study illustrates a situation where a business may be overvalued by a business broker or business owner to the detriment of securing an SBA loan guarantee.

 

            

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