Common sense and business valuation
Valuation approaches and methods are essential to a credible valuation. However, there is no “correct” way to value a business. Valuation is an art rather than a science. Therefore the cornerstones are always informed judgment, common sense and reasonableness. Since informed judgment is such an integral part of a valuation conclusion, the appraiser must make every effort to avoid errors. Among the common errors are:
1. The use of inappropriate methodology
Appraisers often use approaches and methods with which they are most comfortable, even though they may not be appropriate for the assignment. It does not make sense to use public company methods to value closely held, private companies. They are not comparable. It makes no sense to attempt to use earnings methods to value a business that has no earnings. It is not reasonable to value a business whose revenues and earnings have stopped growing using methods that are based on projected growth of revenue and earnings. Majority interests are not valued the same as minority interests. Rules of thumb do not take the place of recognized and accepted methods. Forcing a round peg into a square hole will bring distorted results.
2. Inadequate financial analysis
Financial statements and tax returns are historic, tax-oriented documents usually intended to show income at its lowest, expenses at their highest and profit at its lowest. This however, is not usually the real world, especially when it comes time to sell all or part of the business, or when it comes time to borrow money. At that time owners will often say “But that’s not the real picture!” The professional appraiser needs to see the “real picture” and will recast the financial reports to reflect an economic picture based on the business’ true performance. Appraisers will make adjustments for owner’s perquisites, non-recurring and non-operational revenue and expense, excessive or insufficient owner’s compensation and rent. Assets and liabilities are adjusted to reflect current replacement values and to eliminate non-arms length or non-transferable assets that are disguised to look like operating assets. Valuations based on cash reporting will typically distort the value of a business whereas valuations based on accrual reporting will present a more accurate picture.
3. Failure to investigate the economy, the industry, the area
The appraiser must consider the company history, the industry and the environment in which it operates, such as the expected future of the buggy whip industry; the impact of a major competitor’s invading the territory of a subject business; the impact that a new freeway may have on a business; the impact that outsourcing has on a subject business.
4. Failure to define earnings
There are many definitions of earnings: EBITDA (earnings before interest, taxes, depreciation, and amortization); pre-tax, after tax, discretionary earnings, before owner’s compensation, after owner’s compensation, or any variations of the above.
5. Failure to define standards of value
Certain terms have different meanings depending on the profession using them. For example, the term “fair value” does not usually mean the same thing to an accountant as it does to a business appraiser. It is those differences that are often the basis for controversy and law suits. A standard of value is a type of yardstick by which a business will be measured and include fair market value, fair value, investment value, and liquidation value. This should not be confused with standards of performance such as required by professional appraisal organizations and the IRS.
6. Failure to recognize that people often buy jobs
It is a fact that many people “buy jobs.” The CEO who has been fired several times by takeovers may now be looking to buy a business (a job) where he can’t be fired and one that can afford to pay him for what his lifestyle demands, say $250,000 a year. Even if that CEO is able to invest $1 million in a business, and intends to operate the business hands-on, he may still be buying a job. There are many reasons people buy jobs rather than work for someone else.
7. Failure to obtain market data of comparable companies
There are no public documents relative to the selling details of private, closely held companies. The only transaction data available is maintained in proprietary databanks available to subscribers and members only. Everything else is guesswork! Furthermore, the selling prices of shares in public companies are not comparable with the selling prices of private companies as they operate in two vastly different worlds. A closely held convenience food store cannot be compared with Safeway supermarkets. A cocktail lounge with 16 slot machines cannot be compared with Harrah’s casino.
8. Failure to understand the nuances of a lease.
Relatively few business appraisers are well informed about real estate matters, yet most businesses involve a real estate lease of one sort or another. While “leasehold improvements” is often an entry on a business’ balance sheet as an asset, the reality is quite different. Most leases provide that leasehold improvements (tenant improvements), upon installation, belong to the landlord, not the tenant. They may not be sold, removed, borrowed against, or given away by the tenant. A lease that provides for landlord approval before being transfer is often a device for adjusting the rent in a rising market, in which case the adjustments should be reflected in the recast financial statements.
9. Averaging of values
Appraisers using multiple methods of valuation will often times average the results in order to arrive at one valuation number, even though the methods used may be totally inappropriate. It raises the question, “If I put my head in the oven and my feet in the freezer, does it mean that, on the average, I feel pretty good?” Example: An asset-based method indicates a value of $100,000. An income based method indicates a value of $1 million. The average of those methods would indicate a value of $550,000. By weighting the values, the appraiser’s more reasonable opinion might be that the income method represents closer to 95 percent of the company value, the asset method represents closer to 5 percent of the company value, and the weighted value should be $955,000.
10. Failure to apply a test for reasonableness.
Valuations must be tested for reasonableness. The ultimate test for all businesses is, if the standard of value is fair market value (what a hypothetical buyer would pay, what a hypothetical seller would accept), and if the business is sold at the appraised value:
a. Will the revenue pay for all of the operating expense?
b. Will it pay for reasonable compensation to a working owner?
c. Will it pay for the debt service required to buy the business based on terms and conditions prevailing in the market place,
d. Will it still provide the owner (investor) with a reasonable return of, and a reasonable return on, his/her investment?
Jerry F. Golanty of Reno is a certified business appraiser accredited in litigation support and is the South West Region governor of The Institute of Business Appraisers. He may be reached at 332-4881 or firstname.lastname@example.org.
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