Tina: A company/individual has approached me and wants to buy my business. I am not considering selling my business at this time. Should I have my business appraised?
John: Even if you are not considering selling your business at this time, having your business appraised to understand its fair market value is a good idea. Independent studies have shown that a business owner’s estimate of the fair market value of their business often varies by 50% or more when compared to a subsequent appraisal. For most business owners, their business represents their single largest asset and is a key piece in their overall retirement plan. Thus, a business owner’s misconception about the value of their business could result in sabotaging their overall financial and retirement planning.
In addition, a business owner receives significant additional benefits from a business appraisal other than just learning its value. One of these benefits is obtaining a better understanding of how the business compares to its peers financially through a comparison to industry averages. This financial analysis and comparison to its peers can identify not only company strengths, but also inefficiencies and weaknesses that are negatively impacting business value. At my firm, we regularly consult with our clients about the weaknesses and threats facing their business. We help identify ways to correct these weaknesses and mitigate the threats to help increase business value. Furthermore, business owners can learn what the real “value drivers” are for their business, and a business appraisal can be used as a tool to help actively manage and grow their businesses value.
Independent studies have shown that a business owner’s estimate of the fair market value of their business often varies by 50% or more when compared to a subsequent appraisal.
Tina: What documents do you need from me to appraise my business?
A: Typical documents needed to appraise a business include the following:
Federal income tax returns for the business for the 5 most recent fiscal years
Financial statements for the business for the 5 most recent fiscal years and the most recent interim period available in the current fiscal year (preferably compiled, reviewed or audited by an accountant, but if that is not available then internal financials from QuickBooks can be used)
Copies of any company budgets or financial forecasts for any current or future years (if any are available)
Copies of any organization documents for the business (articles of incorporation, by-laws, shareholder agreements, or other buy-sell agreements). Additional documents beyond these basic documents will vary from business to business based on the type of business and the facts and circumstances surrounding the appraisal.
Tina: What is the "finished product" when a valuation engagement or calculation engagement is performed? How long is the report? Will I be able to understand it?
A: What different types of business appraisals are called and the type of reporting they include varies from firm to firm. They vary because firms have different accrediting agencies, and the standards accrediting agencies hold their members to also vary. However, the more basic type of business valuation is typically referred to by most business appraisal firms as a calculation engagement or an estimate of value. In this type of engagement, the appraiser is not providing their opinion as to the fair market value of the business, but instead is providing an estimate of the fair market value of the business using generally accepted valuation methodologies. The finished product for a calculation engagement or estimate of value often consists of an abbreviated two to five page report attached to approximately 10-15 pages of valuation schedules. These pages summarize the historical financial performance of the business and the various valuation methodologies used to estimate the value of the business.
The more complex type of business valuation is typically referred to as a comprehensive business valuation report or valuation engagement. In this type of engagement, the appraiser performs the substantive procedures necessary to render her opinion as to the fair market value of the business. The finished product is a very detailed report that summarizes the interest being appraised, the purpose of the appraisal, the standard of value utilized in the report, an analysis of economic and industry forces that are currently impacting the business, a summary of the history and operations of the business, a detailed assessment of the businesses’ historical financial performance, a complete discussion of the various valuation methodologies used and any relevant valuation discounts that may be applicable to the interest being appraised, and a reconciliation of value of the various valuation methods. Most comprehensive business valuation reports are in adherence with the Uniform Standards of Professional Appraisal Practice (“USPAP”), which is important for appraisals that need to be in compliance with the “Qualified Appraisal” standards of the Internal Revenue Service. These reports range from 60-100 pages in length.
Well-written, comprehensive business valuation reports should tell a story that allows a reader to read the report from start to finish and understand the appraiser’s rationale and thought process in determining their opinion of value. Thus, in general, comprehensive business valuation reports are easier to understand than calculation engagements, as the brevity of the calculation engagement report does not provide enough information to the reader to understand the appraiser’s thought process and rationale or provide adequate explanation of the valuation methods utilized.
Tina: What can I do if I am not happy with the appraisal I receive from my business appraiser?
A: The first step I always suggest to any business owner is to meet with the business appraiser and have the appraiser walk through the entire valuation report with them. This exercise is invaluable as it helps the business owner to have a complete understanding of the thought process and rationale as to how the business appraiser determined the value of their business. If the business owner is still not happy with the appraisal, a second business appraiser can be engaged to either prepare an entirely new appraisal or to review the first appraisal for its reasonableness, accuracy and adherence to generally accepted valuation methodologies and relevant valuation standards.
The first step I always suggest to any business owner is to meet with the business appraiser and have the appraiser walk through the entire valuation report with them.
Tina: Do I need to sell my entire business? What are my options? Do I need an appraisal if I only sell a portion of my business?
A: No, you do not have to sell your entire business. A buyer can purchase either an entire business or a specified percentage of a business. When selling to third parties, it is generally easiest to sell an entire business, as most individuals buying a business want to have complete control of that business. However, fractional interests of a business can also be sold. We typically find that sales of fractional interests most often occur when a business owner is selling to either:
(a key employee (or employees)
an employee stock ownership plan (ESOP), or
other members of the owner’s family
Fractional interest appraisals often require a business valuation so that the business owner can comply with various tax regulations established by the Internal Revenue Service (IRS). For example, when a business owner sells a fractional interest in their business to a son or daughter, a business appraisal must be prepared to substantiate to the IRS that the price paid for the fractional interest was equivalent to fair market value and that no implied gift has occurred.
Tina: I would like to keep the sale of my business confidential. I worry that my CFO will become suspicious if I start requesting a bunch of financial documents for the appraisal. How can I keep the sale confidential, and who should be informed about the sale of my business?
A: We often have business owners who worry about confidentiality and do not want employees, vendors, and certain other people finding out about the possible sale of the business. Businesses are appraised for a multitude of reasons, and the business owner does not need to inform anyone about the sale until he/she believes it is the right time to do so. In addition, in the above example, if the business owner believes that the CFO is becoming suspicious, the business owner can inform the CFO that a business appraisal is being prepared for insurance purposes or for general estate planning purposes for the owner. This statement usually alleviates the concern or suspicion of the employees. Furthermore, when business owners are working with a broker or an attorney on the sale of their business, the broker or attorney can provide valuable advice as to the timing of any announcement regarding a business sale to employees, vendors, customers, and others.
Businesses are appraised for a multitude of reasons, and the business owner does not need to inform anyone about the sale until he/she believes it is the right time to do so.
Tina: What is a common practice for dealing with accounts receivable and payable when selling a business?
A: When a business sale is structured as a stock sale, the buyer acquires all of the businesses’ assets and assumes all liabilities. However, when a business sale is structured as an asset sale, the buyer acquires only selected assets (and may assume certain liabilities) of a business and places these assets and liabilities in a newly created entity. From my experiences, the most common asset sale consists of a buyer acquiring inventory, fixed assets, and goodwill and other intangible assets, with accounts receivable and accounts payable being excluded from the sale. However, if accounts receivable are being included in the asset sale, we typically also see accounts payable being assumed by the buyer.
Tina: What is the most common method for appraising businesses with less than $1 million in annual revenue? For $1-10 million in annual revenue? For $50 million or more in revenue?
A: This seemingly easy question has a complex answer, as size is not the only factor that guides the appraiser in determining which methods are most appropriate to utilize. The three primary approaches to valuing any closely-held business are an asset-based approach, an income-based approach, and a market-based approach, and within these approaches are multiple valuation methods which can be utilized to estimate the value of a business. The methods selected to value a business vary based on several factors, including, but not limited to, size, type of business, and the percentage of the business being appraised.
Valuation methodologies such as the guideline public company method (which is a market-based approach that compares a business to comparable businesses that are publicly-traded) are generally not used when valuing smaller businesses because of the significant differences in size and operating characteristics between smaller businesses and their publicly-traded counterparts. When valuing a controlling interest, asset based valuation approaches may be applicable, but they are not generally viewed to be applicable when valuing a non-controlling fractional interest in a company. Furthermore, a method for which its applicability varies from industry to industry is the comparable transaction method (which is a market-based approach). This method computes pricing multiples (typically either a revenue multiple or some measure of profitability) from actual sales of businesses similar to the business being valued that are reported in proprietary transaction databases subscribed to by appraisers. Thus, the ability of an appraiser to utilize this method depends on the quantity and quality of the transaction data for the specific business being appraised.
The methods selected to value a business vary based on several factors, including, but not limited to, size, type of business, and the percentage of the business being appraised.
Tina: Do you recommend business owners look for accredited valuation specialists? If so, what are the different designations and what are the differences in the different designations?
A: The most important advice that I give to business owners looking to have their business appraised is to be sure to use an accredited valuation specialist. The most common business valuation designations held by business appraisers are:
Accredited Senior Appraiser (ASA) offered by the American Society of Appraisers;
Master Certified Business Appraiser (MCBA) or Certified Business Appraiser (CBA) offered by the Institute of Business Appraisers;
Accredited in Business Valuation (ABV) offered by the American Institute of Certified Public Accountants; and
Certified Valuation Analyst (CVA) offered by the National Association of Certified Valuation Analysts.
Furthermore, it is important for business owners to note the significant differences in the requirements to attain each designation, with the differences being in the areas of experience requirements, educational training and testing, and peer review of an actual appraisal report. It is widely known throughout the profession that the ASA designation is the most rigorous designation for appraisers to attain as its requirements consist of passing a 15-hour Uniform Standards of Professional Appraisal Practice (USPAP) course, passing an ethics exam, passing four 32-hour classes known as BV201, BV202, BV203 and BV204, having a 4-year college degree or equivalent, submitting an appraisal log proving a minimum of 5 years of full-time business valuation experience, and submitting one valuation report for peer review. Thus, my advice to most business owners is the best way to make sure that you will be receiving a high-quality business appraisal report is to engage the services of an ASA business appraiser.
Tina: Do you have any other tips or advice for anyone buying, selling, or appraising a business?
A: A few tips for buyers interested in acquiring a business include the following:
Do your due diligence prior to acquiring the business
Hire a business appraiser to properly understand the fair market value of the business, as overpaying for the business at the beginning can sabotage future cash flows (if financed) and will reduce your overall return on investment
Be sure to obtain proper legal representation and tax planning, as the proper structuring of an acquisition from a legal and tax standpoint can make a big difference for a buyer.
A few tips for owners interested in selling their business are to:
Start your planning to sell your business a minimum of 2-3 years in advance, as proper planning for the sale of a business helps ensure that you will obtain the highest possible price for your business upon sale
Utilize a business appraiser during the planning process to help identify the fair market value of the business at the beginning of the planning as well as learn the various weaknesses and shortcomings of the business that need to be remedied prior to listing the business for sale to help maximize its value
Be sure to obtain proper legal representation and tax planning, as the proper structuring of a sale from a legal and tax standpoint can make a big difference in the “net proceeds” realized by the seller. My firm regularly works with business owners during the “planning to sell” phase and the additional increase in the value of a business that can be achieved through proper planning is significant.