A bad idea: Using public companies to value a small business

It is common practice among residential real estate appraisers to compare a property with similar properties that have sold. But it would be absurd for that appraiser to compare a single-family home with an industrial property. It is similarly absurd to value a smaller, closely held, business or professional practice using data that would apply only to large, public companies.

Example: A convenience food store with annual gross revenues of $600,000 from food, gas, liquor and commissions from 16 slot machines was being valued in litigation. The C-store appraiser arrived at his value by researching financial data of other convenience stores. The opposing appraiser arrived at his value by researching financial data from Bally's, Harrah's, Caesar's and other major casinos, all with revenues exceeding $400 million. The judge admonished the opposition expert for an opinion based on businesses that were not comparable or even similar.

The cornerstones of business valuations are: informed judgment, reasonableness, and common sense. Does the data actually need to be comparable? What about similar?

The matter was addressed in The Estate of Joyce Hall (Hallmark Greeting Cards) v. Commissioner (IRS). The IRS expert, in valuing the estate, cited only one comparable business, American Greeting Cards. The experts for the estate cited over 20 businesses, including fast food businesses, retail business supplies, etc. that they said were "similar" in operations, marketing techniques and the customers that they attempted to attract. The court sided with the Hallmark experts, thus setting a path for business appraisers to follow. "Comparable" does not mean "identical."

Even so, public companies are not comparable with smaller, closely held, private companies. Among the ways they differ are:

Risk: Smaller companies are riskier than public companies, therefore the returns are unique to each. In normal economic times larger, public companies survive longer than smaller, closely held businesses.

Liquidity: Smaller companies have limited liquidity. Their assets are usually tied up in machinery, equipment, and inventory. Larger companies and public companies are able to borrow and finance more easily.

Access to capital: Smaller companies have greater difficulty arranging for financing than do public companies. The borrowing power of smaller companies is usually limited to the personal assets (real estate, securities, etc.) that an owner is willing to encumber as security for a loan. Public companies may sell off assets or subsidiaries to raise capital, or issue stock.

Diversification: Smaller companies are usually less diversified than public companies. Most smaller companies are in one business only. Public companies are often in numerous businesses. For example, Westinghouse is in the manufacturing business as well as in the communications business.

Efficiency: Smaller companies typically are at the mercy of the owner or operator and do not operate as efficiently as public companies, which can consolidate operations, and can also afford to hire efficiency experts.

Responsibility: Smaller companies are responsible to no one. Public companies are responsible to their investors. If shareholders in public companies don't like the way a company is being operated, they can always sell their shares. When a smaller company is sued and loses, the owner can suffer. When a public company is sued and loses, it rarely, if ever, affects a shareholder.

Control: Smaller companies are usually controlled by a single owner or owners. Larger and public companies are controlled by a board of directors.

Audited financial statements: Smaller companies rarely have audited financial statements. Many do not even have financial statements prepared by accountants. Public companies usually produce audited statements.

Adjusted financial statements: In valuing smaller companies it is typical that the appraiser will adjust the financial statements, converting them from tax oriented documents to profit oriented documents. Financial statements of large companies can rarely be adjusted.

Policy influence: Policy in a smaller company is usually set by the majority owner. Shareholders in public companies do not influence policy. It is the job of a Board of Directors to make and/or change policy.

Sale of interests: Interests in smaller companies are difficult to sell and it sometimes takes years to find a buyer. Minority interest are typically discounted if sold. Interests in public companies are usually minority interests and they can be easily sold; just call your stock broker.

Control: In smaller companies, the owner has total control over operations. In public companies the shareholders have no control over operations.

Management: In smaller companies the owner is usually the manager, or the level of management is small and limited. Public companies can, and do, have many levels of management.

Officer compensation: Compensation is controlled by the owner in smaller, closely held companies. Shareholders in public companies have no say so in how much officers pay themselves.

Jerry F. Golanty is president of BizVal, a Reno-based business valuation and consulting firm. Contact him at 332-4881 or jerrygolanty@bizval.net.


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