Business Valuation Blog | Understanding Buying / Selling a Company

Like many professions, the appraisal industry is full of acronyms that only those well-versed in the lingo can identify at first glance. Here are a couple of abbreviated terms that will factor significantly in the overall valuation of your small business.

EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization

Even the long version of this acronym is confusing to understand. Here is a short discussion of its meaning and purpose:

EBITDA is a measurement to determine a company's profitability or cash flow, however, it may not fully represent cash earnings. EBITDA considers a wide range of factors in business finances. It is considered a universally accepted appraisal measurement and is also used in accounting circles.

From an application perspective, it is used by banks and financial services companies to estimate debt servicing levels. It is also used to compare similar businesses within an industry or market and as a tool to preliminarily estimate a company’s current value using multiples of EBITDA developed from historic databases.

SDE: Seller’s Discretionary Earnings

Seller's Discretionary Earnings (SDE) is a calculation that considers the net profit of a business while adding back discretionary adjustments to show the entire financial benefit provided to an owner.

SDE is a common income measurement calculated when a business is changing hands. Financial data associated with this calculation include EBITDA, as well as other factors that impact a company's value as you engage in a buy/sell transaction.

If you're on the purchase or acquisition side, SDE provides you with the information needed to develop a reasonable estimate of your expected future return, as well as an understanding of realistic expectations for the continued growth of the business. From the seller’s viewpoint, SDE supports an optimal level of value during sale negotiations. SDE allows both buyers and sellers to make informed decisions while preparing to invest in or exit a small business.

In summary, these are only 2 of several acronyms commonly utilized in the business valuation industry. Our next blog will discuss other terminology that may be important to better understand when you decide to appraise a privately owned company.

When it is time to close a business and there are no realistic sale options, there are several steps needed to officially dissolve the company, so no loose ends come back to affect you in the future. One of those requirements is filing forms with the IRS and/or your state for final tax settlement purposes. Depending on the structure of your prior operation, you may need to obtain an independent business appraisal as part of this process.

Here are a couple of things to consider when a final valuation comes into play.

Transfer or Sale of Assets

If your business owns a lot of equipment or vehicles, you will look to estimate a final value if you plan to sell them or transfer the property to another entity, such as a new company, or to yourself. This will show a clean break between when the old business was responsible for the assessment and when the new owner took over responsibility for them.

A machinery & equipment appraiser can complete this report as part of the overall business valuation.

If you own intangible assets such as patents, trademarks, domain names, customer lists, or transferable software, the value of these would be estimated by the business appraiser as part of any remaining goodwill of the company.

Valuation Methodology

The focus of the business closure appraisal will likely be solely on the remaining tangible and intangible assets; however, if there are any remaining accounts receivables, payables, long-term debt, or revenue streams not yet fulfilled, these will need to be considered as well.

The asset approach will probably still be the driving methodology utilized by the appraiser while adjustments are made to take these other factors into account.

In an ideal scenario, when it is time to move on from a business, you will be able to find a buyer that allows you to maximize the company's remaining value. If shuttering the operation is your only option, there will likely be additional housekeeping tasks to take care of before you segue to the next chapter of your career.

To learn more about these requirements, consult your accountant and an independent valuation expert who can provide further insight.

One of the more common requests we receive to complete a business valuation pertains to divorce cases. Whether it is for cooperative mediation or a more complex dispute involving litigation, independent appraisal work is often required when one or more of the parties owns a company that is deemed part of the shared property.

Any type of dispute, whether personal or professional, can be difficult to settle when differing opinions are held by each side. An independent professional appraiser can assist by taking an objective and unbiased view of the business and its underlying assets to estimate Fair Market Value.

The most important component from the valuation perspective is access to complete and accurate information. Without cooperation from all parties involved, the appraisal effort cannot move forward. It is imperative that the requested financial data and background summary of the business be disclosed in a timely manner to avoid delaying the process indefinitely. Once the valuation professional has all the necessary details behind the company, the appraisal can be finalized efficiently and effectively.

Even though the appraiser is typically engaged by one of the ex-spouses involved in the divorce, they have an ethical obligation to not take sides, and their work product is meant to be a tool to facilitate the decision-making required by the judges and arbitrators involved with the overall mediation. There are a number of other issues at stake in a divorce case, and the appraisal may be just one of these; however, differing opinions of value are quite often material in nature and can have a significant impact on the final result.

No one truly wants a divorce to drag out all the way to trial, including the independent experts assisting in the matter. As difficult as the situation may seem for those directly involved in divorces and related disputes, the only way to move towards a conclusion is to assist in the processes required to fairly disclose and measure the value of the assets. Speak with a certified professional appraiser with experience in these matters to learn more.

We discussed in our last post the three most common methods utilized when performing a valuation for small businesses:

• Capitalization of Earnings method under the Income Approach
• Direct Merger & Acquisition Method under the Market Approach
• Adjusted Net Asset method under the Asset Approach

Depending on the overall scope of work involved and the structure of the company, only one or two of these methods may ultimately be relied upon.

For example, let’s look at a typical holding company, which is often structured as more of an investment business versus a traditional revenue-driven operating company. Common holding entities will own assets such as real estate, securities, heavy equipment, mineral rights, or even a group of smaller operating businesses. The assets may be rental properties or those commonly traded in the market. These holding businesses are often utilized to consolidate ownership interests and management structures while creating certain benefits and protections for the owners.

Regardless of the structure or the assets being held, revenue produced by these companies is meant to simply sustain operations as opposed to drive income and profitability. Therefore, appraising a holding company using the income or market approach methods would not be practical. The value of the underlying assets would be more appropriate utilizing the adjusted net asset method.

A business appraiser will need to rely on independent appraisals to confirm the value of the primary assets while adjusting for cash, receivables, liabilities, and other balance sheet items. It would not be prudent to simply rely on estimates supplied by the business owner without these unbiased reports.

Another issue to consider when valuing a holding company is the possibility of a discount for lack of control with the ownership interest being appraised or for a limited degree of marketability. These types of discounts are considered with any small business that has multiple owners for partial buyout or buy-in purposes, or for potential liquidity issues arising from a sale.

Holding companies should not be confused with “shell” companies, which are structured for different reasons, such as tax and accounting regulations, and are often the subject of negative press due to a history of investigations into the validity of certain enterprises. To learn more about appraising holding companies, consult with a certified valuation professional.

A Business Appraisal relies on three broadly accepted approaches that consider all the potential variables that factor into a valuation: The Income Approach, Market Approach, and Asset Approach.

These approaches review and analyze historic performance, reasonable growth projections, and the underlying assets of a company to estimate value. Depending on the circumstances, one or all three will be weighed in the final assessment.

Within these three approaches, there are a multitude of methods by which business value can be measured, however, when appraising a small privately owned company, there are typically only three methods utilized. Here is a brief summary of each:

The Capitalization of Earnings Method under the Income Approach

This method looks at the future projected growth of a business where historic revenues can reasonably predict ongoing trends over the next few years. Future cash flows are discounted back to the present date of the appraisal to establish value on a current basis. This method is most appropriate when a small business has shown a relatively steady level of revenue and income over the last 3-5+ years.

The Direct Merger and Acquisition Method under the Market Approach

This method estimates the prices paid for closely held companies that are in a similar line of business and can be considered comparable. Based on the data available in the market, it develops multiples that can be applied to the gross revenue and discretionary earnings of the business being appraised.

The Adjusted Net Asset Method under the Asset Approach

This method reviews all the tangible assets in the company, including real property, equipment, F&E, and inventory. Estimates are ideally based on an assessment of market value, or if that is not available, net book value. It also factors in cash, receivables, and liabilities to realize a net asset value. This method can be applicable if a business is capital-intensive but not producing a lot of revenue or net income, while also being appropriate for a company that is winding down operations.

In summary, you can discuss these methods in more detail with a certified valuation professional to better qualify which approach would likely apply to your small business. Taking the steps necessary to understand these approaches and methods before committing to a business appraisal will help you avoid any unexpected surprises.

Occasionally, appraisers are asked to provide opinion letters based on a review of another appraiser’s work product or from a company’s internal analysis for which they need independent validation. This process can seem more simple and informal than a typical valuation project, however, the time involved with completing the effort can be as much or even more than an appraisal.

Those businesses looking for a less expensive and time-consuming alternative to a complete appraisal will find the result can often be the opposite. Reviewing third-party work and commenting on their opinions and estimates for reasonableness, creates a two-fold process that can be more complicated than reviewing financial and asset data while estimating value.

At the very least, the appraiser needs to complete a high-level valuation of their own in order to comment on whether third-party opinions make sense or not. In many cases, the analysis required to provide a supportable opinion of another’s work product involves a similar amount or even more work compared with simply providing an independent appraisal of their own.

Opinion letters typically need to be generated from scratch given each project is unique and the requested deliverable will change with each engagement. With standard appraisal reports, most valuation professionals rely on a boilerplate framework that provides a more efficient way in which to develop their narrative summary.

Another issue with requests for review opinion letters is that many certified and accredited valuation professionals are not comfortable providing this type of report. The need to go outside the lines of their normal framework may create too many inconsistencies with the formal appraisal practice requirements that are adhered to in the normal course of business.

“Informal” is not a word appraisers like to use when providing opinions given the uniform standards they must commit to in their profession.

Typically, it will make more sense to have the appraiser complete their own analysis and valuation report which can then be compared to the other party’s work effort. This may seem repetitive and more costly; however, you may be surprised at the additional benefits you will reap when your auditors have an easier time approving the total work product. And there is a high likelihood that the time and cost involved will be very similar or even less when you ask for a more straightforward scope of work to complete the task at hand.

Determining if you need to engage with an independent professional business appraiser will commonly arise when you are looking to purchase or sell a business. However, the fact is there are several other reasons an objective third-party appraisal is a great idea, and quite possibly a requirement to move forward with a transaction or to aid in a situation where a dispute may arise. Here are some examples:

Investor Buy-In or Buy-Out: You will look to have a fair assessment of company value determined to avoid a dispute and support a smooth transition.

Bank (Re)Financing: Virtually every bank or related lending institution will require an appraisal for loan purposes.

Litigation Support: Any legal disputes that bring your business into account will need an independent appraisal to facilitate a settlement or add support in a trial or arbitration.

Accounting and Tax Purposes: There are any number of reasons you will need appraisal work to aid in the review and approval of accounting and tax procedures.

Estate Settlement: When a family member passes and they own a business, a valuation will be an important component to transferring the property.

Development of a Family Trust and Legacy Transfer: When the next generation is ready to step in and take over the family business, an appraisal will be critical to the process.

Donation and Gift Tax: Some business owners may decide to donate their business or extend financial gifts through it. The IRS will require an independent valuation in support of the donated amount for tax deduction purposes.

Internal Business Planning: Looking ahead with long-term company goals from a growth and resource perspective will be much more effective with an appraisal assessment in support of project planning.

Divorce: If changes to your personal life include a divorce, your business, and personal property may become subject to the settlement.

If you find yourself involved with any of these situations, consider engaging with an independent, certified business appraiser to assist in facilitating the process.

If you have owned a business for a number of years and now need an appraisal to sell the company, apply for financial assistance, or bring in new investors, you will need to have reliable financial documentation that provides historical performance details.

The most common records you will need are income statements, balance sheets, and tax filing records. You can provide further information by responding to a series of typical questions the valuation professional will ask during the process, that will give additional perspective on how to view these documents and make discretionary adjustments to the income and expenses of the business.

The appraiser will ask for 3-5 years of these filings, and they should be developed by an outside accounting agency or internal company controller. If you find yourself in a position where these records are not current, or poorly documented, you will need to determine the best way to update them, otherwise, the appraiser may not be able to assist you.

One option is to hire a forensic accountant or bookkeeper who can go through all the business receipts and related paperwork in an effort to develop formal documents which can be utilized for the appraisal as well as support these transactions. A potential buyer, financial institution, or investor is not going to blindly give you funding if the historical performance of the company is not well-detailed and documented.

Keep in mind the appraisal firm you engage with cannot actively participate in the development of these documents since they need to remain independent and unbiased when estimating their value opinions. As a business owner, you will know far more than anyone about the previous performance of the company as well as have access to the records needed to put these documents together. Whether you decide to take this project on yourself or work with an outside agency or internal employee, your direct involvement in the process will be critical.

Regardless of your immediate desire to put the business on the market, or look for new capital funding alternatives, take the time now to review your business records and determine if they are accurate and up to date. Even if they are, take further steps to organize a file to consolidate and provide easy access to, all the historical financial records of the company so that when the time comes, you will be prepared to move forward.

If you are unsure of the steps needed to complete this effort, contact a certified accountant or appraiser who can discuss the process further and give you informal advice that gets you on the right track.

We receive several valuation inquiries every year from companies still in their infancy stages that are looking to attract new investment through private equity or by bringing in additional partners with the right talent to help them achieve their goals. These “start-ups” are often thought to come from the various technology markets, however, anytime an entrepreneur begins the process of developing a business from scratch, regardless of the industry, they are considered a start-up.

With a start-up from a valuation perspective, you will not be able to rely on historic financial performance and the current balance sheet will likely be very limited. There will potentially be some comparable established companies publicly available to research, however, these may not be similar enough to rely upon given the specific business plan the new company is developing.

Most likely, your potential client is looking for the appraiser to rely on a future growth strategy, typically a five-year plan, as the basis for the appraisal, given this data will create a more favorable value conclusion. If you plan to value a start-up company, here are a couple of additional thoughts to consider:

• Ask your client to provide a business plan including forecasted income statements and balance sheets. It is important to advise them that the data needs to be reasonable and supportable, based on as much background and research they have performed and which they can provide details for. If the forecasts look overly aggressive, they will need to come up with as much support as possible to justify their growth plans.
• Advise your client that as a professional appraiser, you do not have forensic accounting capabilities or business planning experience, and therefore, will be relying on the data provided by them to be accurate within reason. The appraiser cannot actively participate in the development and verification of the forecasted data.
• Ensure that your appraisal report includes sufficient narrative summary discussions on the scope of work, advising readers that your value conclusions are based in large part, or even solely, on this future business plan. Add that should the plan not come to fruition, or be considerably different than the forecasted estimates, the value of the business will be materially altered.

If you, as a certified valuation professional, are not comfortable with the information provided by the client and believe it to be unrealistic based on your experience with similar situations, you should discuss this with them and ask that they adjust the data. If you can’t agree on a game plan, you can potentially opt out of the work if that is a contractual option. Valuing start-ups is a challenging endeavor therefore, ensure you have these issues covered before taking on the appraisal assignment.

As valuation professionals, you probably get asked about your expertise in certain industries when bidding on new appraisal projects. This is a reasonable question to receive from potential clients looking to engage with the most qualified candidates, however, your response should be both an honest and thoughtful one, focusing on the realities of industry experience.

The vast majority of certified and accredited appraisers, whether they specialize in business valuation, machinery & equipment, personal property, real estate, or any other discipline, cannot afford to limit their experience to a few specific industries, as this would severely reduce the number of opportunities for work and future growth of the business.

The fact is that companies who focus solely on valuation work and have the necessary credentials and experience as appraisers can effectively value properties across any and all existing industries and market segments. This is primarily because the continuing education and experience derived from working as a valuation professional is focused on implementing consistent and effective approaches and methodologies for appraising any company or asset, regardless of the industry. In addition, the appraiser will always rely, in part, on the specific market segment data and sources developed during the valuation process. Understanding how to research, review and analyze the market and industry data, while independently concluding on a reasonable value, is what separates the experienced appraiser from the rest of the pack.

There is a distinct difference between experience and expertise. As an appraiser, you may have years of experience valuing businesses within dozens of distinct industries, which is useful when potentially working in those same markets in the future, however, your expertise is in valuation and doesn’t need to be industry focused.

There are specific industry consultants who exist to assist their clients in any number of business decisions that can affect a company’s future success. For example, an oil and gas consultant might help their client enter a new energy market segment by developing a business plan that involves various marketing and investment strategies. That is generally where industry expertise comes into play. They may understand the concept of valuation and have certain opinions, however, they lack the training, experience, and expertise to effectively appraise that business.

In summary, it is important to advise your clients of these distinctions and the fact that your expertise is in valuation and not limited to any particular industry. An effective response can help explain that you will consider their specific market and industry as part of the overall appraisal while applying accepted, time-tested methodologies resulting in an independent, supportable conclusion of value.