There are many different types of business valuations and some are more comprehensive than others. Business appraisers also have different methods for calculating value. Why is this important to business owners? Moreover, why is it important for business owners to understand what types of events and activities can have an effect (often times a negative effect) on the numbers? Business valuations are important and the type you need depends on a number of factors. Jeff Allen talks with Mr. C. Fred Hall, Certified Valuation Analyst and CEO of Affordable Business Valuations, to answer some of the most important questions appraisers are asked by business owners every day.
So throughout that period of time it's good to get benchmarks for what your company is doing and what it's worth.
- Fred Hall
What are some of the things that can have a direct or even indirect effect on the valuation of your company? Are these things that you can control? And with so many professionals now providing valuation services how do you know if your business is receiving a fair valuation or not? For some answers to these important questions we've reached out to C. Fred Hall, CEO of Affordable Business Valuations. Mr. Hall is certified business valuations expert and a business consultant with clients nationwide. Fred Hall, welcome to Deal Talk sir, good to have you in.
Fred: I appreciate it. I'm glad to be here.
Jeff: Let me ask you right off the bat, Fred, will an appraisal be helpful in determining if my business is ready to sell? What do you think?
Fred: I think it's an important thing. You really have to see all the issues that come into play and determine the value of a business, and you got to see how buyers react to your business, when it's actually listed on the marketplace. An appraisal really helps you focus on the strengths of your company and your weaknesses. It's a good starting point for an owner to go through the exit strategy process. Determine what the business is worth. If it comes in significantly less than what you think it's worth then maybe you'll just table that process of trying to sell the business until you get the business value up to where you need it to be. So I think the appraiser really helps you to understand the whole process and gives you a good base starting point for valuing your business, what it could sell for.
An appraisal really helps you focus on the strengths of your company and your weaknesses.
Jeff: What I hear you saying, Fred, really through all of that is that because it is a good starting point it is probably important, correct me if I'm wrong, to have your business appraised from time to time. Not just a one-off appraisal. Say, "Boom, won and done, I'm ready to sell my business.” But this is something that you should probably include in your list of to-do's over a period of years and to have your business re-evaluated.
Fred: Yeah, I agree. The exit strategy that an owner should take should be a long-term exit strategy. It should be over the course of one, two, or three years really. So throughout that period of time it's good to get benchmarks for what your company is doing and what it's worth. So yes, a regular annual updated valuation would certainly go a long way to make sure that the owner sees, “I've done these things for my company this year and look what it's done to the value of the business. So that means I can do these things next year, maybe that'll also increase the value a second time.” It's really good to do multiple valuations over a period of time and see where the company's going.
Jeff: Let me ask you another question, Fred, with regard to this. As a business owner I know that I've been successful and I'm just kind of playing the role here, just kind of setting up a hypothetical. And I suspect that my business is probably worth about a million dollars. I'm not ready to sell it. I'm happy doing what I'm doing and I have kind of a long range goal here. But I don't really want to have to pony up for a full 100 percent comprehensive valuation of my business just now. Is there another kind of valuation or appraisal that maybe doesn't, it's not the full enchilada but it gives me a really good idea of what my business may in fact be worth right now? Kind of more of an approximate but something that's fairly close.
Fred: I do, it's a very simplified valuation that I call a snapshot. And I think most appraisers do that as well. But the snapshots are valuations that are directly oriented towards an owner of a business. The only audience that I play to is just the owner. The formal valuations that are very expensive are ones where you're having to submit documents to the IRS or the court, or financing companies. Those valuations have to be very technical and very extensive, and they're very expensive. But when I'm just appealing to the owner to let them know where the market is I can do those very inexpensively. I don't have to do all the market researchers required for an IRS appraisal. So a snapshot’s probably one fourth or one fifth the cost of a formal valuation. The number crunching that we go through in the snapshots is basically the same number crunching that we go through in a formal valuation. We just don't have all the other analyses that goes along with it. The owner of a company doesn't need to know about the industry that he's in. He's been in it all his life. But the banks and IRS need to know that information so you spend five pages on your report describing the industry. So the snapshots are very simple. They're very inexpensive, and you can update quarterly, annually, or whatever, very inexpensively. And you can then get a good benchmark and a turn marker. You're going to see where the valuation of your business is going.
It's really good to do multiple valuations over a period of time and see where the company's going.
Jeff: So you think these snapshots Fred - I'm sorry, I didn't mean to talk on top of you - but these snapshots you think can really be a valuable tool in helping a business owner actually raise, improve the value of his company by seeing where he's at now and where he'd like to be?
Fred: Absolutely. It's interesting, when I'm going through the whole process of a snapshot with an owner I go through a very detailed question and answer period. During this interview I'm asking dozens and dozens of questions about the company. And of course the owner of the company doesn't know what these questions all mean in terms of creating value, but when he gets the valuation report he suddenly sees all these numbers and how they went together and realize, "If I keep on doing this to my business I'm going to improve value. So maybe I should focus on those points in the coming year and I should be able to increase the value of my business faster.” The snapshot does help to focus the owner on the key issues surrounding his business and its ultimate value.
Jeff: That man right there is Fred Hall. He's CEO of affordable business valuations. I'm Jeff Allen. You're listening to Deal Talk. I'd like to kind of now step aside for just a second and talk to you about something else, Fred, that I've kind often wondered about. And that is whether or not valuation professionals such as yourself tend to use the same methodology for calculating appraisals and valuations. We know that there are some different processes but is everybody kind of pretty much doing the same thing out there?
Fred: Well, I'll tell you what. There's probably as many different methodologies as there are businesses to appraise. There's hundreds and hundreds of them and the reason is fairly simple for that is that we're trying to develop a mathematical formula or model if you will that predicts the future. And of course that's impossible. Nobody can predict the future. So we look at the past history and try to make certain assumptions based on what we've seen, and try to extrapolate that into the future. So as a result depending on the company that you're looking, the industry that you're looking at, the state, the economy, and all these factors might mean that we have to use different methodologies to get to the meat of what this company is worth. So you'll see a dozen different companies, valuations done on them and they're all completely different because the companies are in different industries or whatever. And so the appraiser had to use different methodologies to kind of capture all the issues surrounding that particular company. So there's a lot of different methodologies out there. Basically there are two basic models that we use, doing appraisals and whatnot. The most common one is the market approach which is just like in a real estate appraisal where we're comparing your company with a number of companies similar to yours that have sold in the past. So that's a market approach. In income approach we are looking at your company from an investor's perspective. In other words, what kind of rate of return can I expect? What should I be paying for that rate of return? So those are the two basic models that are out there. There are numerous adaptations of each of those models. There's probably a hundred different ways you can do the market approach, and there are a hundred different ways that you can do the income approach. But basically the income approach is basically an investor's methodology and the market approach is a comparative one where you're comparing similar companies that have sold in the past. In any case above and beyond there's numerous methodologies that I've seen appraisers use, but the market approach and the income approach are the basic ones.
But basically the income approach is basically an investor's methodology and the market approach is a comparative one where you're comparing similar companies that have sold in the past.
Jeff: Are you aware, Fred, of any ways that some appraisers out there have misled their clients by maybe giving them essentially an appraisal that, I don't know, is kind of based on a cookie cutter kind of formula for establishing valuation? Can you talk to that at all?
Fred: Yeah. I don't know whether misled, I don't think appraisers intentionally mislead but some of them are not trained properly to be able to do a good comprehensive valuation, so maybe due to lack of training they have produced an appraised value that is not realistic. And I've seen a number of cases where the appraiser often times has an opportunity to gain a long term relationship with his client, and so the appraiser's thinking, “Maybe I should give a very high value to impress the owner of the business.” And I see this occasionally with business brokers who are trying to solicit a listing, and as a result they will put a high value on the business to be able to solicit that listing. And as a result they may spend months and months and months trying to sell a business at an unrealistically high price. Those are the areas where I see misleading in the worst case. For what appraisers are typically doing it's more of a misunderstanding issue that I think surrounds these valuations. So for example I will be interviewing an owner about his business I might ask a question like, "Gee, your inventory has increased a lot over the last couple of years. What's happening here?" The owner isn't sure how my line of questioning is going to affect the value of the business. So he tries to guess what I want to see out of that question. So he might come back and say, "I've been increasing inventory for years trying to push my sales up. So I think if I increase inventory next year I'll get more business as a result.” Then he reads my valuation and finds out the increase in inventory is going to take a huge bite out of his cash flow and that will hurt the value of the business. So sometimes the owner is trying to guess what the appraiser means by a certain question and he is guessing wrong. The best defense for an owner in this situation is to not try to guess what the appraiser means by a question but answer the question is factually and honestly as you possibly can and not try to over-think it. Anyway, that's the biggest issues I see out there that facing an owner to avoid being misled I guess.
Jeff: How closely, Fred, are you involved with the business owner when conducting an appraisal or evaluation? There are certain pieces of information that you need prior to getting underway?
Fred: Yeah, that's always been a problem with me and most appraisers will have this long laundry list of information that we need to get because there's a lot of information that goes into these appraisals. And so you submit a very lengthy list of documents that you want to get from the owner. And the owners don't want to spend hours trying to extract information from their accounting systems. And so they usually send you half of what you've asked for. So you have to kind of try to fight through the process, trying to get everything you need to be able to do a good, comprehensive valuation. So it slows the process down trying to get that information. When I don't get everything I need, I try to make up for it in the interview that I subsequently do with the owners. I’ll spend two or three hours with the owner interviewing him about the nature of the business and all the financials that he's given me. And most of the time I can get the information I need out of those interviews but it really helps the appraiser if the owners of the business will give that appraiser everything that he asked for and not try to hold anything back. And it works to his advantage to do that.
The best defense for an owner in this situation is to not try to guess what the appraiser means by a question but answer the question is factually and honestly as you possibly can and not try to over-think it.
Jeff: I guess if you're going to pony up the money, invest in proper appraisal and something that's comprehensive, you might as well be cooperative with the appraiser really when he or she comes to your door and gets things underway. And remember this is all for your benefit. Fred, I appreciate your thoughts on it. So far that's going to wrap up the first segment of Deal Talk. You're listening to C. Fred Hall, CVA and CEO of Affordable Business Valuations with yours truly. My name is Jeff Allen. We'll be back on Deal Talk after this.
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Jeff: Welcome back to Deal Talk, I'm Jeff Allen with my guest Fred Hall, CEO of Affordable Business Appraisals. Fred it's been really great talking to you so far in this program and I really do appreciate you joining us today. I'd like to talk about the types of things that impact or affect my appraisal as a business owner, and maybe these are things that I have something to do with and some of them are things that I can't really control. Let's talk about it a little bit, starting with the entity. Does the entity of a business make a major difference in the appraisal process itself and in terms of how long that process may take, how complicated it can be?
Fred: Definitely, entity type can affect the value of the business but not all valuations though. The purpose of the valuation that an owner would need done on his business sometimes will dictate whether the entity is going to be an effect on the overall valuation. So for example if I were doing a valuation that was going to be used for IRS purposes, or it's a state valuations or gifting, or things like that, or evaluation that would be for doing bank financing and things of that nature. Those types of formal valuations, I'm going through the whole income approach methodology. And the difference between an S Corp and a C Corp has a significant impact on the value of the business. So C Corps have a disadvantage in that the corporation itself pays the income taxes on the profits. And if the owner tries to remove those profits from the C corp he's taxed a second time in a form of a dividend tax. So owners or sellers of some businesses will find that a buyer is going to be resistant to buying a C corp because of this one double taxation issue. As a result the valuation of the businesses for C corps is going to be less than the valuation of an S corp. But if I were doing a valuation say for example the snapshots that we've referred to where we're just trying to tell the owner what the value of this business is, we're comparing his company with all the other companies that have sold and all the other companies that have sold are collections of S corps, C corps and proprietorships and whatnot. So we're getting kind of a composite valuation of all the different types of entities out there. So if I'm doing a valuation for a business owner I'm not going to take into account the differences that might come into play on entity types. But for IRS valuations and similar valuations I will. In this case if I see a company and an owner comes to me and says I need a valuation, and that company is a C corp I will certainly recommend that if the owner is considering selling his business that he should consider electing to go with S corp as soon as he possibly can to possibly save taxes in the future, and to make the sale of the business a little bit easier. So those are the differences on entities that come into play in the valuation.
Jeff: You just brought up something too I think that's really, really important to mention Fred and that is that you're not just an appraiser but you are a consultant. And so it does help to be able to wear both of those hats because you're really working on the side of the business owner. You're trying to help them improve the value of their company, save money wherever they can.
Fred: Absolutely. Something as simple as electing to go to S corp. That doesn't cost the owner anything to do that. His accountant could fill out a one-page document, send it to the IRS and it's done. It doesn't cost you anything. But if the owner is looking down range, three, to four, to five years before he sells the business, it's a lot easier selling an S corp that has been seasoned for a number of years like that rather than do a C corp. Owners that have a long range exit strategy are the ones that really could benefit from getting involved in the appraisal process as early as they can possibly can and have a business consultant review their company to show them where he can make changes to improve the overall value.
The purpose of the valuation that an owner would need done on his business sometimes will dictate whether the entity is going to be an effect on the overall valuation.
Jeff: Other types of things that can have an impact on the value of a business, let's talk about the overall economy, obviously that's not something that I can control or you can control Fred, or any business owner for that matter. But from your experience, does a recession always have a negative impact on a business' valuation?
Fred: If that business suffers profitability as a result of that recession then the answer is yes. Interestingly enough, I've done some research on this over the last couple of years because I had an awful lot of brokers who approached me and said, “We're seeing a tremendous drop in the multipliers that our companies are getting when we sell them because of this recession.” So I did some research and found out that there was a D-day drop off in the revenue multipliers and cash flow multipliers that we used to estimate the value of a business as a result of the recession. But what I also saw was most of the smaller companies, and these are companies that are doing less than 2 million a year. What I saw happening was that these companies were losing revenue because the overall economy was bad. And as a result of losing revenue, the potential for losing cash flow from the lower levels of revenue was pretty great. But it turned out from what I can see that a great many of the owners who saw the economy beating their companies down a bit suddenly realized that if they wanted to protect their own personal lifestyle they really had to jump into the trenches and start putting in more hours in their company, paring out all the excessive costs that have accumulated in the company and doing everything they can to preserve the bottom line. So I started seeing an awful lot of companies that are sold in the 2007-2010 period where revenues did indeed decline, and moderately so as a result of the recession. But the bottom line only declined slightly because the owner was doing far more now than he had in the past to make sure that the profitability of the company stayed up. So as a result a lot of the companies that are sold during the recession didn't suffer on the price as much as you might think because the cash flow had stayed moderately high as a result of the owner's actions.
But I think today when we're looking at a period of time where the economy's been really strong for the last three or four years and we look into the future and say, “Is the economy going to continue on to do this for the next four or five years?” Well, we could probably make a bet that there's never been a time in our history where there's been a bull market for more than, say, eight years. That's been the maximum. So right now we're at about year six or almost year seven, in a bull market. Odds are that we're going to see a recession sometime in the future. Will this affect the value of their business? It may very well do that. So an owner who's thinking of selling his business, he would probably do well to sell the business at the peak of the economy and the peak of his business’ revenues and profitability, which would probably be right about now. You just really don't want to try to have to sell the business when the economy is declining rapidly because the buyers can only assume the worst. And that will drive the value of your business down.
Jeff: And we know of course that there are some businesses obviously that are recession-proof, not necessarily bulletproof but that aren't as impacted by swift downturns or long downturns in the economy, Fred, but that's probably a story for another time. We could talk about that. We could probably go through that list one by one. What about those situations Fred when you have a partner or a spouse, or the business owner, him or herself involved in a company and maybe their business is successful. But they have their own personal issues. Maybe they've got poor credit, or maybe they've got tax liens, or maybe there's a divorce that is coming down the pipe. Situations like that that are personal issues aside from the business. Can those types of things impact the value of a company?
Fred: I think indirectly they will if the owner changes his focus from the business over to his personal life and kind of takes his foot off the accelerator for the business and starts looking at the divorce issues and whatnot. And I've seen an awful lot of businesses where the business starts to slide sideways and downward because the owner is now focused in a divorce situation. And that's the most common situation. It's just a change of focus by the owners. What I'm doing appraisals for situations where there's a partnership split up or a divorce splitting up the company, when I'm doing appraisals for those types of situations I will interview one of the spouses or one of the owners who are most knowledgeable about the financials of the company and interview him or her for three or four hours. And then I will produce a draft that I give to both parties, both owners or both spouses, and have both parties review what I have written based on the conversations that I had with one of those owners. And that gives the second owner or spouse the opportunity to review what was said and make comments that might change the way I did the valuation. So I usually submit a draft to the owners or spouses during this type of situation so that both spouses or partners can respond to way that I analyze the business. And if there are any changes that one of the partners or spouses thinks is necessary, well they can come back and say, "No, you got this wrong. The partner you spoke to didn't understand your question. This is the right answer." In which case I'll correct or change the draft that I did and then send out to both parties as a final draft. That's the fairest way to handle those situations or those types of appraisals.
So an owner who's thinking of selling his business, he would probably do well to sell the business at the peak of the economy and the peak of his business’ revenues and profitability.
Jeff: Fred, we've got just a couple of minutes left. Let me ask you for your elevator tips. You're in an elevator. You're going up to maybe the 60th floor of a high rise downtown. You've got just a moment or two to share with someone next to you know as a small business owner and you'd like to give them some advice that might help them either improve the value of their business or at least maintain it. Anything at all that you could share, important take aways. Maybe this is something that would even help you as the valuation consultant come in and give them a fair appraisal of their company.
Fred: Yeah, if I were trapped in an elevator with somebody and had to give a 10-second consultation the first point that I would give to any owner of their businesses, to look at your financials, get together with your CPA, clean up the mess, make your accounting as clear and concise as you possibly can. Make it as honest as it possibly could be, get all the personal expenses that you've been burying in the financials in the past years, take them out. And at the end of this year producing a tax return that is squeaky clean. That will go a long way to attracting good quality buyers. They won't look suspiciously at your financials because they are very clean. And the banks, when they're doing the appraisal on the business will have a good, quality looking financial statement to base the value off of that shows the true cash flow with the company. And if you produce a tax return that has their true cash flow showing on it you'll get a much, much higher value out of your business than a tax return that has all kinds of personal expenses buried in miscellaneous, or cost of goods sold, or something like that.
Jeff: Ding. We've reached the 60th floor. I think that's where I said we were going and that's a great advice, Fred, and we appreciate it. We are out of time. I want to thank you so much for joining us today on Deal Talk, it's been a pleasure.
Fred: It's been a pleasure. I appreciate the invitation.
Jeff: C. Fred Hall, CVA and CEO of Affordable Business Appraisals has been our guest expert on this edition of Deal Talk.
If you're a professional who normally consults with small business owners, a serial entrepreneur who owns multiple successful businesses, or a small business owner who has sold a business and you'd like to share your experience with our listeners, we'd like to hear from you about joining as a possible future guest on Deal Talk. Simply give us a call at 888-693-7834. Deal Talk has been presented by Morgan & Westfield, the nationwide leader in business sales and appraisals. So if you're thinking about selling a business or buying one call Morgan & Westfield today at 888-693-7834 or visit morganandwestfield.com. I'm Jeff Allen, thanks again for listening. We'll talk again soon.