Business Valuation Blog | Understanding Buying / Selling a Company

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.

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.

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.

As a business owner, no one knows more about your company, its operational history, and where it’s headed going forward. When you determine the need for an independent appraisal, the ability to work in tandem with the company you choose to engage with will benefit all parties involved.

There are very likely areas within your financial statements you can elaborate on to paint a more accurate picture than simply what the numbers show. In addition, your experience with the markets and industry you operate in will provide added perspective to the appraiser when they research the competition and comparable businesses during the course of the analysis.

Review overhead and expenses to determine if any are discretionary and adjustable to how you might otherwise operate on a leaner budget. Look at what might be considered “one-off” costs in certain years that can be backed out of annual cash flow levels and review special compensation packages to you and your employees which might not be relevant to a potential buyer. You may be claiming a lower net income figure on your taxes each year because of these discretionary expenses. That is a common strategy for business owners each year as they best position themselves before year-end filing.

The goal is to create a normalized, realistic year-to-year snapshot that shows how the business can most efficiently and effectively run without consideration for added unnecessary benefits you may have created over the years for you and your staff.

When a small business changes hands, the new owner will have their own set of circumstances to consider and will often look at the most economical model to begin their operation until they too can create these added benefits once they become successful in the coming years.

From a market and industry perspective, advise the appraiser of local competition and similar businesses that may be public or available enough to make reasonable comparisons. Discuss future areas of growth you may have implemented but have yet to fully realize the added revenue streams.

It’s important to add these levels of perspective where you can so the appraiser better understands your business beyond the standard documentation that they are provided with by you or your financial advisors. The more the appraiser knows about your personal experiences as they relate to the history of your company and its operation, the more accurate the valuation results will be.

When business appraisers value small to mid-size companies, the most common documents that are reviewed will include financial statements going back 3-5 years that track the company’s performance over its most recent history. This data should be indicative of past operational performance; however, the appraiser needs to carefully review what they see on paper with the business owner to fully understand the larger picture and potentially make adjustments in areas such as discretionary/variable expenses and officers’ compensation. This ultimately creates a true picture of the company’s assets, cash flows, and profitability.

As a business owner, this same type of practice should be undertaken internally every year or two so you can carefully review all aspects of the operation and determine where consistent trends appear while uncovering areas that may be more volatile. This way, you can make adjustments to correct deficiencies and further capitalize on the more successful sectors, to create an optimal working environment for the future.

For many business owners, a 5-10% improvement in areas such as market share, gross revenues, costs, and profitability can make a meaningful difference in overall performance. It might free up working capital to invest in sorely needed improvements to your office equipment or make the difference that enables you to hire a new employee to assist with a slow-moving operational area or to build up the sales force. You may determine this adjustment could make you appear more proactive and successful to a new investor or partner looking to come on board in the coming year.

Whatever the desired result, getting into the habit of digging deep into your company’s year-to-year performance to understand better what has been working well and what might need tweaking, is a great practice to initiate, especially for owners looking to get that extra edge over their competitors. This is one example that can create an opportunity to be the best at what you do and allow for continued growth and success.

Business appraisers typically gather a lot of historical financial data when working with their clients on valuation assignments. They review income statements and balance sheets while looking at the market and industry data that all help shape their conclusions. Going back five or more years is not uncommon, while at the same time discussing reasonable future expectations within the confines of the current company profile.

On occasion, however, an appraiser may engage with a new “startup” or a company that’s been in development for years with little to no income that projects a formidable 5-year forecast of significantly higher revenues. How should that appraiser approach the valuation effort without ignoring historic performance or the external data they usually rely on when looking at more traditional businesses?

The answer is largely dependent on the credibility of the forecasted revenues and their client’s underlying reasoning behind these estimated projections. Here are a few questions to ask both the client and yourself as you work through the analysis:

Is the business unique in any way to its competitors or to comparable businesses in the market?

If yes, then it makes sense to focus on those areas to support the projections that might otherwise appear unreasonable on the surface. If the answer is no, then use the available market to create some checks and balances with the forecasted figures.

Has there been any tangible infrastructure developed within the company that sets the stage for realistic expectations of the longer-term forecasted growth?

It is common with a 5-year forecasted projection to aggressively estimate much higher revenues in the latter half of this period. What has been accomplished today that might further enable the appraiser to agree the longer-term outlook is not overreaching?

What degree of hypothetical or extraordinary assumptions is being made to support the aggressive growth?

Is the client making one too many assumptions about the internal structure of the company or making future market predictions that just don’t add up to a reasonable expectation?

Overall, there will be additional challenges with these valuation projects where reliance on heavily forecasted projections far outweigh historic data. As an appraiser, don’t be afraid to question the client if you are not comfortable with the overall picture they are presenting. Have them provide a clear, sensible outline that supports the aggressive forecasts, and ensure you make statements in your report which show the level of reliance you put on the assumptions and conditions. After all, it is your work that will potentially be relied upon by other parties who may be investing in the future of your client’s company.

The SBA (Small Business Administration) loan programs have become even more prominent over the past few years as companies continue to recover from the pandemic and battle continuing economic and sustainability issues. For those who have thrived in spite of these challenges, the need for favorable loan conditions to handle growth needs, such as working capital access, is critical to future success.

While working with your primary financial institution, who should act as the intermediary for your SBA loan application, make sure you understand all of the approval requirements, including the need to obtain appraisals. Depending on the type of company you own, the size of the loan request, and available collateral such as real property, equipment, and liquidity (cash and receivables), you may need to engage with independent appraisers to provide the SBA with accredited, certified valuation reports for any or all of these components to your business.

During the application process with your lending institution, gain an understanding of these requirements early on as it will take time to find the best appraisers for the job. Turnaround time, responsiveness, and flexibility should all be factors to consider when engaging a valuation expert. Don’t sacrifice any of these variables based on a cheaper option, as the decision may come back to bite you. The valuation results may be poorly determined, the process may drag out interminably, and the SBA could even deny the validity of the reports if you engage with an inexperienced, unprofessional appraiser.

The SBA may require only a tangible asset appraisal, for your building, land, and equipment. Other scenarios would reveal a need for an overall business valuation, which would consider all the assets of the company, as well as an income and market analysis.

In either case, the more prepared you are at the outset of the process, the better chance of a satisfactory result and efficient approval process. Obtaining the capital you need at the right time can save you thousands of dollars in both the short and long term, while the application and approval process can be overwhelming. The best appraisers understand all this and will work with you to ensure they facilitate their role in the process, as opposed to hindering it. Don’t forget to rely as much as possible on your direct lender, as they may be able to recommend the right professionals to work with.

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Most business valuations involve a review of historic financial statements and current assets, with a comparison of existing competition for similar businesses in your market. The requirements change, however, when you have a startup operation that has yet to earn a single dollar and is still in its infancy.

Of the many decisions that you will be making during these early stages, how best to provide documentation as to the future value of your business to potential investors, such as private equity and your existing banking relationships, will likely be at the fore. Before you spend every dime of your own investment savings, you will want to consider alternate sources of working capital with these partners.

One of the tools you will need to independently support the value of your startup is a certified business appraisal. Without the existence of historic financial data, the appraiser will rely instead on your forecasted business plan, which will include projected revenue and expenses, as well as the tangible and intangible assets you have already purchased, or plan to acquire in the immediate future. These growth models are typically built over an initial 5-year period, and structured similarly to how typical financial statements and balance sheets are prepared by accountants.

The appraiser will utilize these forecasts to consider the value of your business today, assuming the business plan is realized while discounting the income streams using accepted methodologies for startups within your market and industry sector. They will also compare your growth plans to competitors in these markets who have similar businesses, to ensure the forecasts are in a reasonable range.

It is important to balance common sense reality with your aggressive growth plans, to ensure these potential investors, and your appraiser, are comfortable there is a good chance of success and that the forecasts are in line with existing successful companies. Many startups fail for any number of reasons, but two of the most common are poor planning and overly confident forecasts.

If you can find the right partners, who share your vision, while keeping checks and balances of the plans in place, and there are well-researched, realistic goals set, the chance of success will be much higher. Add a bit of patience and endurance into the mix, and you can set yourself up for the best opportunity of developing a profitable business for years to come.