Correctly pricing a business

Most business owners haven't a clue as to what their business is worth.

The methods they often choose to price their businesses for sale are:

1.

apply the formula they heard at the last trade show;

2.

ask the next door neighbor;

3.

find out how much the competitor sold for and add 10 percent "because my business is better than his." Of course, these methods create problems that can come back to haunt you.

Most trade associations discuss formulas for valuing a business that have no basis in reality.

A service franchisor advised franchisees that their businesses were worth 20 times monthly billings.

A franchisee with monthly billings of $20,000 offered his business for $400,000.

The annual net profit of the business was $60,000.

With a (typical) down payment of 40 percent ($160,000), the seller was willing to finance the balance at 10 percent interest for five years (annual payments - $61,000).

The business was unsalable at that price.

After investing $160,000, working full time in the business, and taking no salary, a buyer would still have to take $1,000 out of his pocket annually just to support the debt service.

Does that make sense? The business should have been appraised and the seller brought into the "real world".

To really understand this, one must draw a comparison with real estate.

Most real estate, especially residential real estate, is priced at what comparable property has sold for.

The data is usually drawn from multiple-listing records and from recorded documents.

Homes are typically appraised because a lender (bank, etc.) requires it.

Residential appraisers typically inspect a property, measure it, go to their records to draw on the comparable sales, make adjustments, fill out a check sheet, and it's done.

As a result the appraisal fee is relatively low.

It is quite different with a business.

Businesses are usually sold by owners direct or through business brokers who rarely belong to a Multiple Listing Service.

Recorded documents do not indicate the sales price of a business.

Even if one knew the price, it would be meaningless unless they:

1.

had access to the business' financial reports and tax returns and knew the profitability of the business, and

2.

had access to the purchase agreement and knew what was included in, or excluded from, the sale (accounts receivable, inventory, accounts payable, furniture, fixtures, equipment) Business appraisers analyze financial reports, recast them from historical documents to economic documents, and examine the economies that impact the business.

They develop capitalization and income multiplier rates taken from private resources and data banks, utilize multiple methods of valuation, correlate the methods, apply sanity tests, and then issue a report, (not a check sheet) all the time adhering to professional valuation standards.

Many buyers of businesses are not a lot better from sellers.

They also attempt to apply magic formulas to arrive at a value, or they accept the opinions of people who are not qualified to render an opinion.

Many are not willing to spend money for an appraisal when offering or purchasing the business.

They would prefer to retain an appraiser when they are faced with litigation.

There is a double-edged sword on virtually every transaction: sellers who say they sold too cheap and buyers who say they paid too much.

If a seller subsequently suspects that he was cheated on the price, litigation will often follow.

If a buyer subsequently feels that the business was misrepresented to him, litigation will often follow.

In most litigation cases, grievances revolve around issues concerning value; they sold too cheap; they paid too much; the business was a loser! To avoid this kind of situation, what should be done: Sellers should have their businesses appraised before they offer them for sale; agents should insist that sellers have their businesses appraised before accepting the listings; buyers should have the businesses appraised before agreeing to purchase.Who pays for the appraisal is a matter of negotiation.

A seller should know exactly what he's trying to sell, an agent should know exactly what he's representing to a customer, and a buyer should know exactly what he's buying.

At least their decisions will be based on informed judgment.

Furthermore, the appraisal should be performed by a third, disinterested, party who has no vested interest in the outcome.

Who should they select to appraise the business? They should select an appraiser who has business valuation credentials.

Mere membership in an appraisal institute, society or organization does not make one an appraiser, especially when the only requirement is the filling out of an application, and paying dues.

Neither does the purchase of an appraising software package.

CPA's, PhD's, MBA's are not automatically qualified to appraise businesses.

There are approximately 340,000 members of the American Institute of Certified Public Accountants (AICPA), yet less than 1 percent of them are accredited in business valuation.

The credentials themselves and the requirements for accreditation must be looked at.

The two premier business valuation organizations whose designations are the most difficult to obtain are:

1.

The Institute of Business Appraisers .

Their professional designations are Certified Business Appraiser, Master Certified Business Appraiser, and Business Valuator Accredited in Litigation.

2.

The American Society of Appraisers.

Their professional designations are Accredited Member and Accredited Senior Appraiser.

Those two accrediting groups are the only ones that require peer review and demonstration of a candidate's ability to appraise based on strict valuation standards.

What does an appraisal cost? Appraisers work on an hourly rate or a flat fee.

The cost depends on how the appraisal is to be used and the type of report required.

A valuation to establish an offering price range usually will not require the research required in a litigation or tax matter.

The cost will also be affected by type of report required: limited- restricted, summary, full narrative.

Also, the better the financial records of the client, the less time the appraiser must spend in deciphering them.

Clients should understand that it is unethical for appraisers to create financial reports.

( Just look at Enron.) Appraisers analyze and report on quality financial reports created by accountants and forensic examiners.

.

Jerry F.

Golanty is a Reno-based Master Certified Business Appraiser, Business Valuator Accredited in Litigation, and is the South West Region governor (Nevada, California, Arizona, Utah, Hawaii, the Far East-Hong Kong, Singapore, Japan) of the of the Institute of Business Appraisers.

He may be reached at 775-332-4881, golanty@busvalue.com, golanty@callatg.com, www.nationalbizvalue.

com