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Business valuation processes

Jerry F. Golanty

Business valuations consist of a number of phases.

First and foremost is fact gathering that includes research: where is the economy headed (nationally, regionally and locally); where is the industry headed; what have comparable businesses sold for and what do the financial reports and tax returns look like?

The next phase consists of analyzing the collected data, developing financial spreadsheets; normalizing (recasting, adjusting) the financial statements by converting them from tax-oriented documents to profit-oriented documents. A weighted average of gross revenue, discretionary earnings and earnings before interest, taxes, depreciation, amortization is arrived at. Capitalization, multiplier, and discount rates are developed to be applied to weighted revenue and earnings. The appraiser must then decide which approaches and methods are appropriate for valuing the specific business. Included are:

* The cost approach, which is a balance sheet approach that looks at the solvency of a business; assets vs. liabilities, and determines the adjusted net worth of a business;

* The income approach, which looks at what investors require in the way of return of, and on, the investment, considering the risks inherent in a subject business (return, liquidity, marketability, etc.). Income methods include a capitalization of net income (EBITDA) and discounted future benefits (cash flow or earnings);

* The market approach, which views a business based on what comparable business have sold for. The method used for private, closely held business and professional practices are typically the direct-market data method that considers ratios of gross revenue and discretionary earnings to the selling price.

There are no specific methods for valuing specific businesses.

In multiple ownership businesses, an interest of 50 percent or less is considered to be a minority interest subject to discounts for lack of control and marketability.

Often times a valuation will incorporate several methods for example, the excess earnings method of valuation incorporates a cost approach and an income approach (net adjusted book value and capitalization of net income (EBITDA).

After values are established under each method, they must be weighted according to their relevance to the operation of the business. The “arrived-at value” must then be tested to determine if it makes sense.

The test for reasonableness asks: “If the business is sold at the appraised value, will the revenue pay for all of the operating expenses, the debt service, a reasonable compensation for a working owner, and still leave over a reasonable profit?” The valuation will either be validated or the appraiser must go back to the drawing board.

The appraiser will then typically issue a report in a form that meets the requirements of the client; (letter opinion of value, summary report, or all inclusive full narrative report.

Valuations and reports should meet professional standards of performance. IRS, USPAP, IBA and ASA standards require:

* An effective date of valuation (an “as of date”).

* The purpose for the valuation. Litigation support, business planning, tax issues, financing, sale, etc.

* The function: To determine a specific standard of value: fair market value, fair value, etc.

“Standards of performance” and “standards of value” are not the same.

Typical standards of value are:

* Fair market value: The concept of “willing buyer/willing seller” (minority interests could be subject to discounts for lack of control, lack of marketability.

* Fair value: A proportionate share of the whole.

There are numerous misconceptions about business valuation.

Accountants are not automatically qualified to appraise businesses. Few accountants hold meaningful certifications in business valuation.

Business appraisers are not licensed. Some belong to national organizations that certify business appraisers. There’s a big difference between a member and being certified.

There is nothing meaningful recorded in a business transaction. Even if the selling price was known it would have no meaning without the financial reports and the escrow documents (what was included in the sale? Inventory? Equipment? Accounts receivable? Accounts payable? What were they worth?).

Business valuation certifications (accreditations) are not all the same. INC. Magazine noted in a 2003 article, “There are two senior certifications for which you should look when retaining an appraiser. The ASA (American Society of Appraisers) gives out an ASA (Accredited Senior Appraiser) certification which requires courses, exams, five years of experience and peer review of reports. The IBA (Institute of Business Appraisers) certifies its CBA (Certified Business Appraiser) in much the same way.”

What is peer review?

Before granting certification, a panel of experts examines the appraiser’s work and determines whether the candidate performs at a professional level.

Cost can be on an hourly rate or a fixed rate. When it’s on a fixed rate the appraiser estimates the time required to complete the assignment.

Do not hesitate to ask the appraiser for a resume. experience in valuation and do not hesitate to ask the appraiser if he/she has appraised retail, wholesale, manufacturing, personal service businesses before. However, qualified appraisers are taught and trained to appraise all types of businesses.

The appraiser will probably ask you to sign a letter of engagement and retainer agreement. The retainer required will typically be 50-75 percent of the estimated cost with the balance due periodically or on completion. Out-of-town clients may be required to post retainers of 100 percent of estimated costs.

Jerry F. Golanty, president of Reno-based BizVal, is nationally certified in business valuation and litigation support. Contact him at 332-4881, or jerrygolanty@bizval.net..