Figuring capitalization rates on businesses

An attorney recently asked me, "Exactly what is a capitalization rate? I've heard it in court numerous times."

The answer is "the rate of return required by owners/investors for the risk they are taking by owning or lending on a business." Rates are set by the market. Among the risk factors are liquidity and transferability. What would be the risk in a fad business, here today and gone tomorrow? What would you consider the risk to be when valuing the practice of a solo brain surgeon? Is there transferable goodwill in a that surgeon's practice? A real estate lender always considers "What would he do if he's forced to foreclose on the property? Who would operate it until it is resold?" In fact, there are many property management companies out there.

In the case of a business loan, what would a lender do if forced to foreclose on the business or professional practice; especially if specific licenses or specific education is required? There is no question that the risk is greater in a business than it is in most real estate, and the greater the risk, the greater the return must be to an owner/investor.

Whereas a real estate investor might be satisfied with a return of 9 percent on invested capital, a business investor might require a 20 percent return, again based on risk.

There is no appraisal literature that establishes specific capitalization rates for a specific business. Each business or practice must stand on its own two feet. Investors, buyers, and appraisers must therefore examine each business or professional practice to determine:

Gross revenue trends: Declining revenue may be due to poor service, poor merchandise, competition, the general economy, declining location, pricing, all of the foregoing, other.

Cost of goods: Are they in line with the industry? Example: A paving company also owns the mixing plant where it is able to buy product at prices cheaper than its competitors. Question: Would a new owner be able to buy product at the same price? If not, what would the cost of goods be?

Operating expense: Are they puffed or realistic? A business has family members who work, but do not get paid. Conversely, a business has on its payroll the owner's son who is actually away at college. The business owner also owns the real estate where the business is situated but charges insufficient or excessive rent. The owner takes excessive or insufficient salary.

Profit: Is it based on discretionary earnings (what an owner puts in his pocket including salary, perks, benefits, etc.) or on EBITDA (earnings before interest, taxes, depreciation and amortization), before or after owner's perks and after owner's compensation?

Labor: What's available in the labor market? What kind of training is required? What is employee retention?

Management: How many managers are required to operate the business? Who manages besides the owner? What kind of special education or training is required?

Sales: Who makes the sales? The owner, a sales staff, or a manager?

Pricing: On what is pricing based? Bidding, the market and competition, some other approach?

Financial statements: What is the quality of the statements? Are they prepared in- house or by an accountant? Are they cash or accrual reports? Are tax returns available?

Location: How important is location? Retail businesses require pedestrian and/or vehicular traffic. Certain business require being located near freeways. Traffic or parking may be a consideration.

Lease: What is its quality? Rent (net or gross), term, options to renew? What are restoration requirements?

Re-locatability: How easy is it to move the business if necessary? Retail space may be very difficult to find. Machinery may be expensive to move. New leasehold improvements may be required.

Economy: Is the economy (local, regional, national) improving or declining?

Industry: Is the industry established? Is it seasonable? Is it a fad industry such as Pet Rocks?

Desirability: Garbage collecting, street cleaning or shop keeping?

All of the above are typically taken into consideration when establishing a capitalization rate, and impacts on what an owner or investor will require in the way of a return of the investment, and on the investment.

Jerry F. Golanty, a Master Certified Business Appraiser certified in litigation support, is chief executive officer of BizVal in Reno. Contact him through www.bizval.net or at 775-332-4881.