7 Deadly Sins of Startups from a Valuation Perspective

With unemployment high and good job opportunities scarce, many displaced workers are taking the entrepreneurial route and starting their own businesses.  They are hoping their skills from years of employment, often at large companies, will translate into successful small business ownership.  Many are purchasing franchises or existing businesses, while others are using their own ideas or hobbies to start their own unique businesses.  As a result, Small Business Administration (SBA) guaranteed loan applications have soared and ROBS (Rollovers as Business Startups) plans that enable workers to rollover funds from 401k retirement plans to purchase or start a business without adverse tax consequences, have flourished.  The valuation analysis required by both these funding mechanisms has revealed common flaws in these new businesses.  This discussion will consider seven common “sins” of business startups from a valuation perspective.

1.    The First Deadly Sin—No Financial Projections

The value of most businesses is the sum of the present value of the cash flows expected to be generated in the future.  Amazingly, many entrepreneurs and new business owners are unable to provide a set of financial projections or budgets and the underlying assumptions.  Many believe that growth of the business will just happen and that they will react to that growth by paying the bills, making purchases, etc.  The most successful small business owners prepare, in advance, a forecasted income statement (or budget) and balance sheet that detail: expected revenue growth over the next three to five years, cost of goods sold, fixed costs or overhead, profitability, and how this translates into cash flow, the need for additional asset purchases, etc.  The financial projections may show, for example, that the business will not reach break-even in the first year and that the business will incur financial losses that will use cash on hand or require additional cash infusions to continue operations and pay the bills.  The financial projections may also reveal that the company is unable to service any debt or generate sufficient cash flow to enable the owner to take a salary.  All of these are significant problems that a relatively simple set of financial projections should reveal to the new business owner.

On the flip side, many startup business owners do create a set of financial projections, but they are based on underlying assumptions that are unrealistic.  For example, some startups may be expected to experience rapid growth in the first few years; however, there is a limit to that growth and the ability of the business to sustain that growth.  With growth of a startup come certain expenses that should be anticipated, such as the need for additional staffing, supplies, purchases of raw materials, etc.  Failure to plan and anticipate this can lead to cash flow problems.  Cash is king for any business.  Lack of cash or lack of access to funds to support operations can quickly lead to bankruptcy and closure of the business.

From a valuation perspective, the lack of financial projections, or providing unrealistic financial projections without supporting assumptions, suggests to the business appraiser that the entrepreneur is “wet behind the ears” or fails to understand the implications and necessity of financial planning.  Typically, this has a negative effect on the likelihood of success and therefore, on the current and projected value of the business.

2.    The Second Deadly Sin—No Formal Business Plan

Along the lines of the first deadly sin, the lack of a formal business plan is also common among small businesses and startups.  New entrepreneurs often mistakenly believe that opening a business and putting a sign outside is enough.  It is usually the business plan that segregates viable businesses from an entrepreneur’s hobby that they hope to make into a business.  In some cases the hobby may be a viable business.  Successful entrepreneurs create a thoughtful and realistic business plan prior to opening the business to determine if the business is feasible both financially and operationally.  The business plan includes aspects such as how the business is going to market itself and generate revenues, its target market, operational plans such as staffing requirements, supplier analysis, capital budgeting or expectations regarding the need for fixed assets to start the business or maintain operations and meet growth demands, etc.  The business plan is the roadmap for the entrepreneur, telling where they are going, how they are going to get there, and what resources they need to get there.  A business plan that is well thought out and researched does not necessarily have to be a one hundred page document, but it should be sufficiently long to provide insight into the expected operations and “path” of the business.

The lack of a formal business plan in the valuation process once again suggests that the entrepreneur may not understand the importance of planning for various aspects of the business.  Just as the absence of a business plan bodes poorly for the value of the business, an unrealistic or haphazardly prepared business plan also instills little confidence in the business appraiser with regards to the entrepreneur’s ability to be successful.  A similar statement can be made about the likely confidence level of prospective investors.

3.    The Third Deadly Sin—No Break-even Analysis

A key part of the financial projections and business plan is for the entrepreneur to conduct a break-even analysis.  The traditional break-even analysis reveals what level of sales a business must achieve to cover both the variable costs (cost of goods sold) and the fixed costs (overhead), resulting in $0 profitability.  Beyond the break-even point, the business should be generating profits.  Until the company reaches its break-even point, the business must have adequate financial resources to pay the bills and fund ongoing operations.  Conducting a break-even analysis should enable the entrepreneur to test the reasonability of the business plan and financial projections.  For example, if the business needs to produce and sell 5,000 widgets per month to reach break-even but the capacity is only 4,000 widgets per month, the entrepreneur has a significant problem and will either need to cut costs to lower the break-even point or increase capacity to produce more products.  In addition to traditional break-even analysis, an entrepreneur may conduct a cash flow break-even, which shows how much must be sold for the business to begin generating positive cash flow.

A business appraiser will often consider the startup’s break-even point in the analysis of future returns and risk.  The break-even analysis can make the difference between the business having a value of $0, implying that perhaps the business won’t survive, and a positive value and future prospects.

4.    The Fourth Deadly Sin—Operating On Shoestring Budget/No Working Capital

Too often, entrepreneurs believe the business will quickly generate enough cash flow to sustain operations and, thus, enter into the new business with insufficient financial resources.  They may try to operate on a shoestring budget until the business reaches cash flow break-even out of necessity due to a lack of access to additional financial resources.  This may involve getting behind on paying bills, which could hurt the business’s credit and relationships with suppliers and vendors.  Obviously, in the absence of access to additional funding sources or lines of credit, the lack of cash also can quickly result in the closure of a business.  Unexpected or unanticipated expenses can quickly lead to financial problems and growth constraints for shoestring operations.  For example, the need for an additional employee to accommodate demand, but not having the funds to hire, can constrict the business’s growth and profitability.

But just as important, business growth changes a business’s working capital.  For example, more sales create more accounts receivable and accounts payable.  The payables can’t be paid until the receivables are converted to cash without using other cash resources.  This lag can create cash flow problems for any business, particularly a startup whose financial resources often are more limited.  Adequate business planning and financial analysis at the outset can help identify potential working capital needs at various critical points in the company’s growth, enabling the entrepreneur to make arrangements for lines of credit, additional capital, etc.

From a valuation perspective, businesses that operate on a shoestring budget have high operating risk, which tends to increase overall risk and lower overall value.  In addition, inadequate working capital or lack of planning for working capital needs tends to increase the financial risk profile of a business and lower the value as well.

5.    The Fifth Deadly Sin—Lack of Startup Managerial Experience

While many startup entrepreneurs have experience in a corporate setting, few have had experience actually running an entire operation on their own.  In a corporate setting, there are already established relationships, financial resources, and managerial depth across other key functional areas of the business.  Usually, in a corporate setting, the functional areas are also managed by different people.  For example, human resources handles hiring and staffing issues, accounting handles the financial aspects and bill paying, the marketing department handles the marketing, and so on.  The entrepreneur who has come from the corporate world has likely been predominantly working in their own functional area with their unique and specialized responsibilities (except in some instances when they have been a high-level executive with full P&L responsibility).  In the entrepreneurial setting, however, they typically must wear several different hats, handling and overseeing sales staff, the accounting function, marketing, etc.  Those entrepreneurs who do not have significant cross-functional experience are often starting their business at a disadvantage, which may be evident in the lack of a business plan, financial projections, and other factors as previously discussed.  While startup ventures often require the entrepreneur to be the “chief cook and bottle washer,” no one can do it all; in most cases, it cannot be a one man show (with the exception being some professional services).  The most successful entrepreneurs have a solid understanding of all functional areas, but also surround themselves with other individuals who may have more experience in particular key aspects of business operations.  For example, a restaurant owner who is also a chef may have a mastery of back of the house operations but limited experience with front of the house operations, necessitating an individual with a skill set to fill that gap.

The business appraiser will typically consider the entrepreneur’s experience or lack thereof in valuing the business.  Individuals with little or no experience are usually considered much more risky than individuals with extensive business backgrounds, particularly if their experience is in the same industry of the new startup.  A higher entrepreneurial risk profile stemming from lack of experience will likely result in a lower value for the business.  While it is not always the case, a more extensive background and level of experience may tend to reduce the risk profile of the startup and increase the value, all else being equal.

6.    The Sixth Deadly Sin—Unrealistic Growth Expectations

Planning for too little growth and trying to play catch up when growth exceeds expectations creates a number of challenges, such as the need to expand operations and capacity and the resulting requirement for capital expenditures and potentially, additional financial resources.  However, planning for too much growth is just as bad, if not worse, in that overinvestment in equipment and materials reduces asset efficiency and return.  As mentioned before, some startup businesses are likely to experience extremely rapid growth in the first few years of operations.  However, the growth of a startup is not limitless and is bound by, among other factors, the business’s capacity to produce its goods and services.   It is easy for an entrepreneur to exhibit “irrational exuberance” when it comes to growth.  In creating growth expectations, the entrepreneur should first consider the maximum potential output of its goods or services based on available equipment, human capital, etc.  Growth over and beyond that level will require additional capital investment, as well as more financial and human resources.  In forecasting growth, the entrepreneur should, of course, also take a close look at the potential demand for its goods and services by considering the markets being served, the competition, and the potential market share that the company may gain given the size, scope, and competitive landscape.

Unrealistic growth expectations typically are easily spotted.  For example, a maker of gourmet marinades has initially good growth potential.  However, its facility can only produce enough cases annually to equal a 1% total market share.  Based on the competitive landscape, the company would need significant investment in advertising to build brand awareness in order to potentially increase its market share to 5%.  However, the revenue expectations as expressed in the company’s financial projections suggest production in the second year that is beyond the facility’s capacity and the financial projections do not account for additional capital expenditures or advertising campaigns.  Fixed costs grow by only 2% in the financial projections, yet by the fifth year, revenues for the company imply a market share of over 15%!

Based on these inconsistencies, the growth expectations obviously are “pie in the sky”.  The business appraiser will likely notice this glaring error, which tends to undermine the integrity of the financial projections as well as the credibility of the entrepreneur.  As a result, the value is likely to be negatively impacted.

7.    The Seventh Deadly Sin—No Risk/Return Analysis

One of the most difficult considerations for an entrepreneur is the risk/return analysis of the potential business venture.  An incomplete or poorly-reasoned risk/return analysis on the part of the entrepreneur may lead a savvy financial investor to turn down a potential investment in the business in favor of an apparently less risky opportunity.

Even in a world with the global financial system and markets turned upside down, there is a relatively clear relationship between risk and return.  An investor in a higher risk investment should be compensated with a higher return.  For example, an investor in a risk free asset such as US Treasury bonds would expect a return of roughly 4%.  An investor in a publicly-traded, blue chip company (a utility company, for example) may expect a dividend yield of 5-6%.  Corporate bonds have returns of 5% and higher.  A well diversified investment portfolio may have a return in the 6-12% range.  “Junk bonds” have returns of 12% or higher.  Venture capitalists expect annual compounded returns anywhere from 30% and up for “risky” equity investments in startup ventures.  Entrepreneurs should recognize that owning their own business involves significant risks.  As such, any investor (whether it is themselves or a financial buyer under the fair market value standard in business valuation) would expect a return significantly higher than that on Treasury bonds, a diversified portfolio of publicly-traded stocks, etc.

For example, suppose an entrepreneur invests $500,000 of his or her own money into their business.  For the first two years, they expect losses which they finance with external debt.  After three years, they are projecting a net cash flow to equity of $20,000, representing actual cash available for distribution as a dividend at year end.  The return in this case is only 4%, which is hardly enough to compensate for the level of risk.  A financial investor would likely opt for any one of a number of other potential investments that offer a higher projected return for an apparently lower level of risk.  For the entrepreneur, however, the investment in the business only makes sense if they factor in their $20,000 net cash flow along with their projected salary and benefits of $50,000, for a total return of $70,000 or 14%, in year three.  The financial investor will receive no salary, so the return calculation is not as attractive for them.

Many entrepreneurs are new to the business world and are overwhelmed with emotions that may tend to cloud their investment decisions.  The most successful entrepreneurs are those who proactively address the seven deadly “valuation sins” of business startups prior to starting operations.  Business owners who are reactive in dealing with these “sins” generally find themselves at a disadvantage, which can often lead to failure.  Entrepreneurs should seek to maximize the value of their business.  To do so, they must address these seven deadly sins or be prepared to face the negative valuation ramifications.

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.

 

            

Top 7 Business Valuation Questions

Often times, the methodology, theory, and application of financial principles used in a business valuation may be unfamiliar to user of the report—the purchaser of a business seeking financing using SBA guaranteed loans, the seller of the business, the banker, etc.  The following top ten business valuation questions have been compiled in an effort to briefly address some of the most frequent concerns regarding a business appraisal.

1.    What approaches do you consider in valuing the business? 

The approaches that the appraiser must consider to derive an indication of value include:

Income Approach—The Income Approach derives an indication of value based on the sum of the present value of expected economic benefits associated with the company.  Under the Income Approach, the appraiser may select a multi-period discounted future income method or a single period capitalization method.

The capitalization method estimates the fair market value of a company by converting the future income stream into value by applying a capitalization rate incorporating a required rate of return for risk assumed by an investor along with a factor for future growth in the earnings stream being capitalized.  This results in a value based on the present value of the future economic benefits that the buyer will receive through earnings, dividends, or cash flow.  The capitalization method is based on the Gordon constant growth model that uses a single period proxy of future earnings to determine the present value of the asset.  This method is usually employed when a company is expected to experience steady financial performance for the foreseeable future and when growth is expected to remain fairly constant.

Multi-period discounted future income methods involve discounting a projected future income stream on a year-by-year basis back to a present value using an appropriate discount rate that reflects the required rate of return on the investment (compensating for risk).  For the final year of the projection period, the income stream that represents the expected income stream in perpetuity is capitalized to arrive at a terminal value, which is then discounted back to a present value (at the same discount rate) and added to the present value of the prior years’ income streams to arrive at the indication of fair market value.

This method is most commonly used when the company is expected to experience a period of abnormal growth or when the growth rate for the near-term is anticipated to be significantly different from the long-term rate of growth.  This is predicated upon the ability to create a reasonable forecast of the company’s income stream for the forecast period.  If these conditions are satisfied, the multi-period discounted future income method may more reliably capture the value impacts of cyclicality or abnormal short-term factors impacting the company’s results than a capitalization method.

Market Approach—The market approach derives an indication of value by comparing the company to other similar companies that have been sold in the past.  The guideline publicly traded company method uses the prices of similar and relevant public companies as guidelines for determining the value of a closely held business.  The direct market data method relies on transaction data of similar closely held businesses to determine an indication of value.

The premise of the guideline publicly traded company method is based on the economic principle of substitution stating that one will not pay more for an asset than the amount at which they can acquire an equally desirable substitute.  Revenue Ruling 59-60 indicates that the market price of stocks in corporations having their shares actively traded in a free and open market can be an indication of value when the transactions in such freely traded companies are sufficiently similar to the company being valued to permit a meaningful comparison.   The guideline publicly traded company method is appropriate when similar and relevant proxy companies may be identified and employed in estimating the value of a closely held company.

The direct market data method develops an estimate of value for the subject company through use of transactional information on actual sales of a large sample of closely held companies.  Sources of transactional data may include databases such as The Institute of Business Appraisers (IBA) Transaction Database, Pratt’s Stats, DoneDeals, Bizcomps, etc.  Though similar to the guideline publicly traded company method, there are several major differences that distinguish the two methods.

Under the guideline publicly traded company method, a small number of companies are selected as being similar to the company being valued.  They and their stock prices are compared to the company being valued to arrive at a value estimate.  The direct market data method, however, assumes that the sample of transactions for which market data is obtained represents the statistical population of the market for similar businesses as the one being valued.  The company is then compared to the market based on its relative strengths and weaknesses with respect to financial condition, performance, etc.  The preliminary value of the company is then estimated based on the prices at which other companies have sold.

The direct market data method is usually employed when there is a large enough sample of transactional data of similar and relevant companies to develop a reliable indication of value.

Asset Approach—The Asset Approach adjusts a company’s assets and liabilities to their fair market values and adds to the balance sheet the value of intangible assets and any contingent liabilities.  While tangible assets can be appraised and reported on an adjusted balance sheet accordingly, the valuation of intangible assets such as reputation, employee talent, etc. is more complicated.  One method of deriving an indication of value under the asset approach is the excess earnings method.  Though the excess earnings method has been used in a variety of cases such as marital dissolution or economic damages, the use of the excess earnings method in valuing the equity of a company is not widely accepted by all business appraisers.

Given that most business valuations are typically conducted under the premise of a going concern, the appraiser may determine that the asset approach is inappropriate for determining an indication of value.  However, the appraiser may test if the company is worth more in liquidation as opposed to as a going concern by utilizing an asset approach.

2.    What discounts may be applicable?

The most common discounts applied in business valuations are the discount for lack of control and discount for lack of marketability. 

The International Glossary of Business Valuation Terms includes definitions these terms:

Discount for Lack of Control—an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control. 

Discount for Lack of Marketability—an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.

3.    What is the difference between a full appraisal, a limited scope appraisal, and a fairness opinion?

Full/formal business valuations typically consider and utilizes all relevant approaches and methods that the appraiser considers appropriate in determining a value.  These valuation reports typically include research on the subject company’s industry, economic conditions, trends, etc.

Limited scope business valuations may not include all approaches and methods in the process of determining an indication of value and may provide either a specific value or a value range.  Analysis of the company, industry, and other factors that may impact the value may not be as extensive as that performed for a formal valuation.

Fairness opinions are typically rendered in a merger or acquisition context to the target of the transaction to provide an opinion of whether the proposed value of the contemplated transaction is “fair” for the shareholders.  Fairness opinions may also be provided in dissenting shareholder situations.  Fairness opinions do not typically provide an estimate of value or value range.

4.    What are the main credentialing bodies for business valuation, what designations do they offer, and what designations have you earned?

The four main credentialing bodies in the business valuation profession are the National Association of Certified Valuation Analysts (NACVA), the Institute of Business Appraisers (IBA), the American Society of Appraisers (ASA), and the American Institute of Certified Public Accountants (AICPA).

NACVA offers the Certified Valuation Analyst (CVA) designation.

The IBA offers the Master Certified Business Appraiser (MCBA), the Certified Business Appraisers (CBA), Business Valuator Accredited for Litigation (BVAL), and Accredited in Business Appraisal Review (ABAR) designations.

The ASA offers the Accredited Member (AM), the Accredited Senior Appraiser (ASA), and the Fellow Accredited Senior Appraiser (FASA).

The AICPA offers the Accredited in Business Valuation (ABV) designation.

A CVA must have a qualifying degree from an accredited college or university, have two years experience in the profession (or have completed ten valuations), pass a comprehensive examination and submit a complete written valuation report/case study to examiners for peer review.  CVAs must participate in continuing education in valuations and observe the ethics, reporting standards, and practice standards of NACVA.

To be awarded the CBA designation from the IBA, the candidate must hold a business degree from an accredited institution of higher education, possess a prerequisite understanding of business valuation theory and practice, and demonstrate a minimum of 10,000 hours of prior work experience in business valuation.  The candidate must also complete in-depth IBA coursework covering various aspects of valuation theory and application, methodology, and report writing and pass a comprehensive examination.  The final step in earning the CBA designation is the successful completion of the peer review of two demonstration reports submitted by the candidate.  To maintain the designation, a CBA is required to obtain continuing professional education in business valuation.

5.    What is the difference between enterprise value and equity value?

These two terms are the most commonly confused terms in business valuation.  There is a significant difference between enterprise value and equity value, even though many people use the terms interchangeably.  Enterprise value is often referred to as the value of the invested capital of the business which includes the value of the equity and the value of the firm’s liabilities.  This value represents the total funding of the asset side of the balance sheet for all fixed assets, cash, receivables, inventory, and the goodwill of the business.  Equity Value is the enterprise value less all liabilities of the business and represents the value that has accrued to the shareholders through retained earnings, etc.

As various professionals may define these levels of value differently, it is important to understand exactly what a definition of a level of value includes or excludes under the specific circumstances delineated in the business valuation report.

6.    Do you use rules of thumb when valuing the business?

Rules of thumb are simple pricing techniques that business brokers typically use to approximate the market value of a business.  Tom West compiles the Business Reference Guide: The Essential Guide to Pricing a Business (published by Business Brokerage Press) which is a valuable reference for many business brokers and is considered the definitive source of rules of thumb for pricing small businesses.

Rules of thumb typically come in the form of a percentage of revenues or a multiple (usually between 0 and 4) of a level of earnings, such as seller’s discretionary cash flow.  For example, a rule of thumb for pricing a widget manufacturer may be 40% of annual revenues plus inventory or two times seller’s discretionary earnings (pre-tax net income + depreciation + interest + salary for one owner/operator at the market rate of compensation).  Rules of thumb fail to consider the specific characteristics of a company as compared to the industry or other similar companies.  In addition, rules of thumb do not reflect changes in economic, industry, or competitive factors over time.

Widely-accepted business appraisal theory and practice does not include specific methodology for rules of thumb in developing a value estimate, as there is typically no empirical evidence relating to how the rules were derived or if, in fact, the rules are reflective of transactions in the market.  As such, business appraisers do not use rules of thumb in determining an indication of value.  However, rules of thumb can be useful in testing the value conclusion arrived through the appraiser’s selected approaches and methods.  Such sanity checks are a way for business appraisers to test the reasonableness of their value conclusion.

7.    What are the main factors that impact the value of a business interest?

The value of a business interest is impacted by a number of factors, many of which may change from year to year.  Some of the factors that impact the value of a business include the following:

  • Financial performance—If a business has poor earnings capacity or is on the verge of bankruptcy, the value of the business is going to be negatively impacted.  If the business has strong historical earnings but is currently experiencing a downturn due to exogenous factors such as temporarily higher steel or energy prices, the value of the business may or may not be negatively impacted if the business appraiser can reasonably conclude that the favourable earnings trend will resume in the future once these transitory factors pass.
  • Growth prospects—There are two ways a business can achieve profitability, increase revenues at a higher rate than expenses or cut expenses.  Just as too high a rate of growth may lead to negative operational and financial consequences, too low a growth rate may also have a negative impact upon the business and its ability to achieve profitability.

Revenue growth drives all opportunities for the business to expand.  If the business’s revenues have grown at a high rate in the past but are now subsiding to a more sustainable long-term rate, the value of the business will be impacted.  Likewise, if the business has declining revenues due to new competitors in the market or a loss of market share, the value of the business will be negatively impacted.  If the business is experiencing stable revenue growth comparable to the long-run rate of growth in the economy, the value of the business may not be significantly influenced.

  • Competitive nature of industry—If the industry in which the business is operating has become more competitive due to the entrance of new competitors, the value of a business may be impacted as a result of lost market share, lower revenue growth, shrinking margins, and lower profitability.  Consider the impact home improvement retailers such as Lowe’s and Home Depot have had upon the smaller hardware stores.  Many of the smaller hardware stores have survived but have experience a downturn due to the increased competition which has greater purchasing power and more market share.
  • Ownership, control, and management—The value of a business interest is impacted by the control of the enterprise.  A control owner’s interest in most cases is valued more highly than a minority interest that lacks control and the ability to make decisions or influence the direction of the business.

If a business has several shareholders as opposed to a single owner/operator, the value of the business may be impacted.  Consider the situation where a business has two partners each with 50% ownership.  Neither has complete control over the business, leading to the possibility that the partners may become deadlocked over an issue.  This may negatively impact the value.  If there are multiple shareholders, there is the possibility that no one has control.  If the shareholders are fractious, the value of the business may be impacted.  However, if the interest being valued has swing vote value, for example, the interest may be more highly valued than other minority interests.

Management of a business also influences the value of the firm.  A highly experienced management team and an organization with managerial depth is more highly valued by a willing buyer than an organization with only one manager or key executive.  In a situation where there is only one executive, the value may be negatively impacted by a key person discount.  In larger organizations, management transparency is often a factor that may influence the value of a business.  Businesses with more transparent management often are more highly valued by buyers than those where management is more opaque.  This is particularly the case when there are multiple shareholders who are relying on the management team (either other shareholders or the hired managers) to run the operations.

  • Economic and industry condition—The strength of the economy impacts all businesses in one way or another.  If adverse economic conditions translate into long-term lower growth and profitability for a business, the value may be negatively impacted.  Industry conditions are also impacted by the state of the economy but are also influenced by various other factors such as competition, technological change, trends, etc.  For example, the plastic injection molding industry has been negatively impacted by the trend towards production in lower cost countries such as China.  Thus, both economic conditions and industry trends have may either a positive or negative impact upon the value of a business.  The business appraiser must use informed judgment in determining if the economic and industry conditions are transitory or if they will have a long-term impact upon the business and, thus, the value estimate.


 

Fair Market Value vs. Strategic Value

Buyers and sellers often have a different perspective relating to the value of a business.  While both hope to achieve their desired results, reconciling these value differences is often one of the most challenging aspects of effecting a successful transaction and can be a stumbling block for SBA loans.  Business owners with too high expectations may find themselves unable to sell the company because a prospective buyer may not be able to get financing.  In transactions, greed is not necessarily good;

Strategic buyers of a company seek to maximize the return on the transaction through the long-term creation of value by capitalizing on synergies—financial benefits that may be the result of economies of scale, integrated marketing, horizontal or vertical integration, etc.  If the acquirer pays too much for the business and the synergies never materialize, value may well be destroyed.  Overpaying for a business could have adverse long-term consequences for the value of the company and its shareholders.

Individual buyers of businesses are significantly different than strategic acquirers.  Individual buyers are usually looking to “buy a job” for themselves or their family members.  While they may be assessing the acquisition in terms of the ability to provide a lifestyle for their family or simply receiving a return on their investment, other non-financial factors often influence individual buyers.

Thus, it is important for both the buyer and the seller to be familiar with the differences in fair market value and strategic value and how these value estimates affect the ability to consummate a transaction, particularly with respect to obtaining SBA guaranteed loans.

For those individuals seeking to buy a business via a SBA guaranteed loan, the SBA may require an independent, third party appraisal from a business appraiser with one of several professional credentials.  The appraiser is typically engaged to provide an estimate of the fair market value of the business being acquired.  The SBA will not usually accept a valuation based on strategic value.  Thus, the relevant standard of value for SBA loan financing is Fair Market Value.  IRS Revenue Ruling 59-60 of Internal Revenue Code Section 2031 defines Fair Market Value:

[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

For valuation purposes, fair market value includes several assumptions inherent in the definition.

First, property changes hands in an arm’s length transaction between the willing buyer and willing seller.

Second, the hypothetical buyer and seller are rational investors.  As rational investors, they assess economic and financial factors in relation to the subject interest in order to determine a price at which the transaction will be conducted.

Third, the willing buyer is a financial buyer rather than a strategic buyer.  A willing buyer does not have synergistic opportunities in the transaction.  The willing buyer, then, assesses the transaction only upon the potential for return on invested capital by utilizing a comparable management team.

Given that the willing buyer does not possess any special value-adding factors or synergies that will enhance the value of the business, the fair market value may be lower than the highest price that could be obtained in the market.  The fair market value provides the value of the business on a stand-alone basis.  To a buyer seeking a financial return only, the fair market value represents the maximum amount that the buyer should paid to acquire control of the future cash flows associated with the business based upon the risk characteristics of the company and the buyers’ required rate of return that reflects the relative level of risk of the cash flows.

Fair market value is also the minimum amount that a seller should accept in a transaction.  It is easy to see that the actual price at which a transaction is consummated may vary greatly from the fair market value based on the particular situations surrounding the seller and the particular motivations of the buyer.  Both buyers and sellers should remember that price is the monetary consideration negotiated between the parties whereas fair market value is a “theoretical” price or standard of value developed by a professional business appraiser that utilizes a number of methodologies and assumptions regarding risk and return for the universe of willing buyers and sellers—not that of particular parties to a transaction.

Unlike stand alone value, which measures the value to the universe of willing buyers, strategic value measures the value to a particular buyer that seeks to capture synergies by combining like operations or complementary operations.  The overriding goal of undertaking an acquisition that produces synergies is to create shareholder value of the combined entity that exceeds the value of the individual, stand alone companies.

In nearly all cases, strategic value produces a higher total transaction value than fair market value.  The following illustration depicts the relationship between fair market value, strategic value, and synergies.

sba

Buyers and sellers should be cognizant of the difference between fair market value and strategic value and how these differing standards of value impact a transaction using SBA guaranteed loans.  The fair market value standard excludes using the buyers’ expectations regarding growth in sales, new marketing initiatives that will increase sales, cost cutting initiatives that will increase profitability, budgets and forecasts, changes in cost structure due to decisions made by the buyer or as a result of the buyer’s relationship with suppliers, etc.  If the buyer of the business is paying the seller more than fair market value, the buyer is paying the seller for the synergies that he or she will be brining to the table by completing the transaction and will likely be unable to obtain financing for any difference between the fair market value of the business and the purchase price.  This may require the buyer to put in additional cash in the deal structure or the seller finance the difference.

Buyers who do not understand this may engage in transactions that significantly reduce their ability to capitalize on the synergies or unique qualities they bring to the business and may not be able to successfully finance the deal using SBA guaranteed loans.  Sellers who want more than the fair market value of the company risk turning away potential buyers who are relying on SBA guaranteed financing.  As a result, the transaction itself may be doomed to fail on various levels.