Business Valuation Blog | Understanding Buying / Selling a Company

It’s fortunate for those in the professional valuation industry that people have different opinions and perspectives on the same topics. Otherwise, there would be a lot less demand for independent appraisal work.

In this utopian fantasy world, certified and accredited valuation reports would still be needed in certain markets, such as accounting, banking, and insurance requirements; however, much of the litigation work that appraisers take on would essentially be eliminated altogether.

Most experienced appraisers rely on a significant portion of their business to come from these types of projects where disputes arise. Lawyers who practice business law, as well as divorce attorneys, who often represent the clients directly in these cases, would also have a difficult time staying relevant.

Many experienced appraisers will work with these clients on dispute work, which will come from a number of different situations. Here are a few examples:

Partner Buyouts

One of the most common types of disputes. What is the value of a partner-owned company, and how should discounts be applied to minority interests? Both of these opinions will vary, and the odds of coming to an easily compromised settlement in a buyout are low.

Liability Damages Claims

One business suing another for a deal that goes “sideways” usually involves a liability case where damages occur as part of a transaction or event. The odds of these cases working out on an amicable basis are even more remote, given the parties involved arguing over not only the extent of the loss but also who is responsible. People generally don’t like to admit or accept blame for anything in business or personally.

Divorce Cases

We’ve all seen the statistics about how many marriages end in divorce. It’s rather sad that this is the reality. However, as an appraiser, you can bet one side or the other will reach out to you when there are company and/or tangible assets involved with the split. Sometimes, the assets are jointly owned, and on other occasions, only one ex-spouse has an equitable interest. Either way, there is a lot of unsettled disagreement when trying to formalize the separation fairly.

All of these situations will ultimately require an independent third party to step in and assist with facilitating a settlement or arguing their case in court. For the qualified appraisers out there, this creates a multitude of opportunities to generate steady sources of revenue and growth.

EBITDA and SDE are the two drivers behind valuing a business under the Direct Market Data Methodology, using a company's profitability and cash flow while factoring in market-based multiples that apply to these figures.

What is EBITDA and SDE?

EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization, while SDE stands for Sellers Discretionary Earnings.

EBITDA looks at a company's reported net income and adds back the components listed above. SDE adds back variables such as the owner's salary, non-cash and one-time expenses, interest on debt and non-operating expenses.

Other adjustments may be made to these figures based on the particular business and how the owners account for certain expenses and compensation. Under this approach, a market-based multiple is then applied to these calculations to estimate value.

It is uncommon for an appraiser to estimate value using both EBITDA and SDE, so which of these should be relied upon when valuing a business? This is typically determined based on the size of the company and its net income level. The other consideration relates to the involvement of and reliance on the owner to run the operation.

For example, suppose a small business has a net income under $1,000,000 annually and is heavily reliant on the owner's involvement. In that case, SDE should be the measure, given that owner compensation is a major component when adjusting profitability.

On the other hand, with larger companies with net incomes higher than $1,000,000 and the owner's role being less critical to running the business, EBITDA should be the focus. If the owner already has a management team in place, there is no need to rely on the owner's compensation as part of the earnings adjustment.

As a result, EBITDA will typically be less than SDE, and the multiples applied are higher than SDE, given that the prospective new owner will not have to work full-time to run the company successfully.

In summary, once the business appraiser understands the company's structure and net income history, they can make a sound decision about whether to rely on EBITDA or SDE when valuing your business.

When accredited/certified appraisers value businesses, equipment, and personal property, they are taught to consider and ultimately rely on a consistent set of approaches and methodologies, regardless of the industry or type of asset being appraised. This fundamental component of professional valuation principles may be the most important topic to understand in the valuation field. Without this set of guidelines, appraisers could essentially do whatever they wanted in support of reaching their conclusions, which would lead to an unregulated industry that could not be properly governed by the organizations that oversee it.

That being said, the particular types of property being appraised, along with the markets and industries in which they operate, will dictate their own set of variables that will influence value under these fixed approaches and methodologies. Depending on the overall scope of work and available data, they may also lead the appraiser down a certain path of relying on specific approaches over others.

For example, in business valuation, the multiples and risk premiums relied upon under the market and income approaches may vary considerably depending on the specific company and industry involved.

Another example in machinery and equipment appraisal is that the available market data for new and used equipment will dictate how much weight can be placed on the cost and sales comparison approaches. The useful life and effective age of a particular asset will also affect its value.

These distinct variables will influence value within each market and industry; however, the appraiser needs to stay within the lanes of the acceptable approaches they are taught to consider and rely upon.

It’s perfectly acceptable to exclude certain approaches if the data isn’t there to support them or the situation doesn’t call for it. For example, the income approach is rarely used when appraising machinery and equipment, however, it is one of the more common methods when valuing businesses as a whole. This is due in part to the difficulty of tying revenue and expenses directly to the underlying tangible assets of a business.

The premise of value being considered will also factor into the equation. If a company and its underlying assets are being liquidated and are no longer a going concern, then the approaches and methodologies relied upon will be different.

In summary, every valuation project will have its own distinct components within it, however, the appraiser must consider the same set of accepted approaches regardless of the situation.

When potential new clients inquire about our valuation services, we are often asked how much experience we have in a particular industry. The fact is that an appraisal expert cannot focus a significant amount of time on any one industry if they want to maintain steady revenue and grow their business. There are nearly 100 major industries in which companies operate, and appraisers need to apply their skills to any or all of them to create a diverse valuation practice effectively.

Appraisers go where the opportunities take them, regardless of the industry in which their clients operate. Fortunately, if a professional valuation expert has been working for a long time, they have likely completed a certain number of appraisals in several different industries, which increases the odds they have experience in the ones they are being asked about.

Clients need to understand the distinction between industry and valuation expertise. They are two very different functions that will sometimes intersect but primarily demand professionals to focus on one or the other. As an appraiser, I find it fairly simple to develop an aggressive learning curve when working on projects within any of these industries. Combining the market research they conduct for each project and direct client communications will allow them to understand better what they need from an industry perspective to complete an effective valuation.

The standards and methodologies learned and employed by certified and accredited appraisers apply to every industry they work in. All the educational time, effort, and application of these accepted approaches are consistent for any company being valued. The more experience a valuation expert has will further reinforce the understanding that employing these methods in every project they complete will provide greater support and credibility to their analysis and reporting process.

It is important to comprehend the nuances of the industry you are valuing. There are databases and market sources that provide this kind of information at the fingertips of any appraiser who knows where to look. This data will influence the valuation conclusions and is typically based on a considerable number of comparable companies within the same industry.

In the end, regardless of the level of experience an appraiser has in any particular industry, they will be able to provide a credible and dependable valuation of your business if they hold the proper credentials that make them experts in the appraisal industry.

We speak with small business owners daily about their interest in obtaining a valuation, usually for a specific and immediate purpose. The reasons typically involve any of the following:

• The owner is going through a divorce
• A partner wants to buy out their shares, or a new investor wants to buy in
• Refinancing or SBA Loan requirements to obtain working capital
• A potential sale or acquisition of a small business
• Estate Settlement/Transfer or Gift Tax
• Setting up a Trust
• Litigation Support
• Internal Business Planning

The last one listed here is the most interesting because it tells me that a business owner is likely thinking proactively to better prepare themselves for future development plans, ideally in the company's longer-term growth planning stage.

Rather than waiting for something to happen that triggers a more urgent need for an updated small business valuation, it might make sense for owners to have professional appraisers conduct annual valuations of their business so that whatever happens down the road, they will be better prepared to face the challenge.

We often witness an owner's hesitation to move forward with an appraisal once we provide a scope of work summary and fee quote. This may be a matter of cost or unwillingness to commit to the work effort involved. Whatever the reason, it's important to think about the decision not only in terms of the immediate need but also with an eye on the additional benefits an appraisal can provide as you continue to be a successful small business owner.

Partnering with a third-party consultant such as a certified appraiser, tax planner or investment advisor, can give you additional perspective from an "outside-in" view that can help you along the way as the company continues to evolve. I think you'll find that the additional time and investment involved with this type of engagement will be minimal in comparison to the overall benefits of fully understanding the worth and potential of your small business.

Let us know if you would like to discuss these topics further by reaching out to us through our website. We would be happy to speak with you personally.

We have worked with many clients and their attorneys over the years in support of ongoing litigation where the value of a small business and its underlying machinery & equipment is at issue with either a divorce case or an insurance claim. We have seen several situations drag out indefinitely at significant expense to the parties involved, ultimately leading to a court or arbitration hearing. The final judgment is ultimately left in the hands of a judge or arbiter who must pore through a significant amount of testimony and documents before rendering a final opinion that may or may not be favorable to those with a stake in the decision.

In rare instances, innovative ideas have been put forth by the opposing legal teams along with the judges or arbiters to create a more efficient and effective process toward settling on value issues as well as other components in a dispute. If both sides have engaged with independent valuation experts or other outside consultants who have no bias in the matter, they look to utilize them more directly and collaboratively during the pre-trial phase. The idea is for the experts to work together and come to a reasonable agreement on value, which avoids the need to carry these issues into the testimony component of the hearing or trial.

From our experience with this type of process, it has proven to be successful largely as long as the experts respect each other’s backgrounds and opinions while keeping an open mind when negotiating an agreed-upon value for their clients. The only times we have seen this alternative effort falter is when one of the independent consultants digs their heels in with only their specific interests in mind, irrespective of the other expert opinions, ultimately refusing to assist in the process reasonably.

There will always be cases where the parties are so far apart, and there are very high stakes involved that this process may not apply. However, many small business disputes involve disparities that are not that significant.

The big-picture goal of any professional consultant involved with a business or personal dispute is to be part of a team that aims to facilitate a fair settlement that hopefully works out for all parties involved. It’s improper for a professional accredited appraiser to focus their effort solely as an advocate for a particular side of the dispute. If they do, then their independence and unbiased opinions no longer apply. It’s fine if the valuation expert advocates for their work product and the conclusion of value they support. However, those opinions will always have a degree of subjectivity to them. It is incumbent on them to realize that different experts with varying experiences and points of view should be able to find common ground to help all parties involved with litigation dispute work.

The type of small business you own and its operating history will largely dictate how a certified valuation analyst (CVA) will approach appraising your company. The industry-accepted methodologies considered and ultimately relied upon will play a material role in determining its overall value. Here are a couple of examples:

Scenario 1: If your business has been established for several years in a competitive industry and has shown steady revenues with modest levels of annual growth, then it’s likely the CVA can use both income and market-driven approaches to value. The income approach will consider this consistency and create a discounted cash flow analysis utilizing the Capitalization of Earnings Method. This approach will consider your adjusted net income and create a future income stream which can then be brought back to a current date using an appropriate discount rate.

Under this scenario, the appraiser can also consider and rely upon two types of market approaches, one driven by your company’s annual gross revenues and another by your adjusted net income. By applying multiples to these figures derived from similar market comparable transactions for your industry and business type, the CVA will be able to estimate value.

The result will create three different value perspectives, which can be weighted equally or favor one approach over another depending on the reliability of the variables involved.

Scenario 2: If your business is in its infancy with minimal to no historical financial data behind it, or if it is in a somewhat unique market, then it is likely the CVA will only be able to rely on the income approach to value. In this case, they may look for you to provide a reasonable 5-year forecast which can be factored into the analysis while utilizing whatever financial data is available. Startups looking for new investment for working capital are examples of this as well as companies who operate in niche markets where no comparable data is available.

Scenario 3:  Your business has been in existence for a long time but stagnating over the past few years, possibly as a result of the COVID pandemic, or other market factors, with stabilization and future growth becoming highly unlikely. In this instance, the market approach may be the only option as the income of the business has been inconsistent and unreliable.

In summary, it’s always important to take a proactive approach when obtaining a valuation of your small business. Speak with a certified appraisal professional to learn more about what options will work best for you.

You’re a small business owner who has spent years developing and growing your company from a start-up to a fully established operation. Now that you have reached your initial long-term goal of becoming a successful enterprise, you can start thinking about the next chapters.

Are you content to maintain the current profile of the business and hope for consistent revenue with modest growth over the next 5+ years, or potentially capitalize on your expanded knowledge, market share, and client base to take a bigger leap forward that could possibly put the company in the next tier of small businesses?

To put this in perspective using an arbitrary example, let’s say a small landscaping business just surpassed $1,000,000 in gross revenue with a 20% profit margin after doubling these figures compared with 3 years ago. The business hasn’t needed to take on any additional working capital or expand its employee base over this period to realize this initial level of growth.

The business owner may determine two forward paths over the next 5-year plan that will shape the company's future. The first would be to remain content with the fact that they have reached this initial goal and can look to grow 5%+/- per year based on their existing structure and try to trim expenses and improve profit margins by 10-15%.

This scenario would keep the current employees and clients happy and allow for a steady income stream for the owner who might want to retire or sell the business to its employees or a competitor sometime in the next few years.

The second option would be to take an aggressive growth position now that the company is firmly established with a broader goal of doubling or tripling the size of the company over the next 5 years. What might be a reasonable strategy to accomplish this loftier goal?

The first may be to leverage the existing demand and reputation the company has in the existing market areas while realizing that hiring additional employees would enable them to take on the extra work without overtaxing their current staff. This may lead to significantly increased gross revenue but might reduce profit margins given the expanded overhead.

Another strategy might be to research your competition in nearby market locations and attempt to acquire one of these businesses and expand the company’s territory. This effort would require a lot of due diligence to target the right business and might require a working capital loan to purchase the company. The short-term effects may result in lower margins and a greater risk associated with the transaction, however, the potential of creating a more diversified business with immediately impactful growth results will go a long way to increasing the value of the company.

Either path you decide to go down will be an exciting one.

Many of us know how difficult it is when you are going through a divorce, and as a business owner, the stakes are even higher. On top of the anguish and mental toll, a divorce can take on you personally, if you own a company or your soon-to-be ex-spouse owns one, and you need to consider this asset as part of the settlement, the first thing you will need to do is obtain a current valuation. This will provide a professional, unbiased assessment of value for the business so you have one less thing to try and negotiate a fair compromise on.

Your first reaction as a business owner might be reluctance toward opening your financial records to your attorney or your spouse and their attorney. That type of mindset could also bleed over to the appraiser, making it very difficult to properly complete the valuation. Consider taking the high road in this circumstance, which is always recommended when dealing with any type of messy situation that needs to eventually be resolved before the parties can move on.

It's ok to have disagreements on the value of your personal and business assets with other interested parties in any kind of situation, however, the only way to work through them to a reasonable end is through cooperation and full disclosure. Otherwise, the resolution process will take much longer without any guarantee that the outcome will be more favorable to you.

When it comes to working with outside third parties, such as an appraiser, the more information they have that is accurate and well-detailed, the more supportable and accurate the valuation will be. Also, consider the additional benefits of having a third-party valuation of your company completed. For example, you can rely on it as a basis of negotiations for future investment or financing purposes. Or down the road, you may want to sell the business or buy out a partner. It is much easier for a valuation professional to update the appraisal after having recently completed it, which will save you time and money going forward.

Having a long-term perspective when it comes to personal and business decisions usually pays off and provides additional unforeseen benefits down the line. Creating an efficient and effective plan now, even if it pertains to a divorce or other difficult situation, will allow you and the other parties involved to see the “light at the end of the tunnel”. This sense of optimism in the face of conflict will most likely result in the best possible outcome.

A business appraiser can work with you and assist in the valuation process, ultimately providing you with a detailed defendable report that you can work with to help resolve any type of dispute, including divorce. Be proactive in engaging with a certified professional so you have one less thing to worry about as you work through the settlement process.

One of the most exciting and daunting experiences for a business owner is when the time comes to sell the business. After years of hard work, development, and growth, the day eventually arrives when you believe the best option is to cash out and move on to the next chapter of your life.

One of the most essential steps in the selling process is to obtain an independent valuation of your company so you can understand the fair market value of the business as a whole, as well as the underlying tangible assets and goodwill. The appraiser you choose to work with should be certified through the NACVA, ASA, or some other nationally recognized association. Make sure you discuss their credentials before moving forward.

If you own a lot of equipment and real estate as part of your asset base, you should first engage with accredited appraisers who specialize in those areas before completing the full company valuation. Once that’s complete, the business appraiser will include those value estimates as part of their review, along with the rest of their analysis.

Take time to go through your financial documents with the appraiser so they understand the adjustments that should be made to non-recurring and discretionary expenses so you can present the optimal profitability of the company. Two of the key variables in the analysis will be your gross revenue and adjusted net income (EBITDA), along with the potential for future growth, which can be determined based on a reasonable forecast of future revenue over the next 3-5 years.

Since you are selling the business, as an owner, you are expected to settle the liquid assets and liabilities reported on your balance sheet, specifically the cash, short-term receivables, and any outstanding debt. Hopefully, the net outcome for these is positive, so in addition to the value of the business, you can walk away with additional cash to supplement the overall sale price.

The buyer understands that when they purchase the company, they will need to develop their own sources of cash flow, whether that be personal capital, taking out new loans, or developing equity from investors.

Selling your business will likely take a lot of patience and communication to provide all the necessary support documentation to potential buyers, and you may want to engage with a business broker familiar with your industry and markets, who can assist with the overall process. In the end, make sure you are comfortable with all the terms of the deal, and carefully read through the documentation involved. Consider hiring a business attorney to make sure you have all your bases covered and when it is all over, take a deep breath and enjoy what comes next.