Tina: What methods do you use to appraise a high potential startup with no revenue? For example, an online company with $500,000 invested in web development with positive revenue, no profitability but high growth ahead.
Michael: In the past, I have mainly used discounted cash flow models, relying on an anticipated exit value as the terminal value. However, I find that I am increasingly relying on market-based methodologies as I have become more aware of reliable data being available and as I have improved my understanding of how the markets for such businesses operate.
For example, a number of emerging companies are publicly traded, which opens the door to the guideline public company method. Looking at public markets for startup values is particularly fruitful in the biotech space. You can find numerous pre-revenue companies in clinical trials that are traded as pink sheets, and there’s no obvious reason to think that those market prices are materially inaccurate in terms of value, particularly if the stock trades relatively frequently.
Further, we started using PitchBook a couple of years ago, and it contains a great deal of data regarding startup transactions and valuations. Accordingly, the transaction method becomes available as we gain insight into the pricing and terms of many early-stage venture capital-type transactions, allowing us to use them in our analysis.
In addition to improving the robustness of our valuation analysis, these techniques also provide the client with useful intelligence as to how the market currently prices businesses such as theirs.
In rare cases, we will use real options modeling and simulation where the investment/return timeline is long and the company development process complex, such as in pharmaceutical research or aerospace.
Tina: In many lower-middle market businesses, investment bankers do not recommend an appraisal. Do you feel a business appraisal is necessary for companies looking to sell in the lower-middle market ($5-50 Million in Annual Revenue)?
Michael: An appraisal is almost never necessary to sell a business. It’s also not necessary to appraise your home before selling it or to look up the Blue Book value of your car before selling it. But few would argue that those aren’t good ideas. For small business owners, that business likely represents most, if not all of their net worth—why would you not commission an appraisal before putting it on the market?
An appraisal is desirable for the following reasons: a) it empowers the sellers to manage the investment bankers—to know that when the banker is telling the seller that they have a good deal on the table, it actually is; b) the seller can avoid wasting time or being distracted by low-ball offers; c) the seller can avoid wasting time if their price expectations are unrealistic; and d) the seller can learn how to attract higher prices from bidders by changing certain things about their business.
I work with many investment bankers who prefer to put a business on the market that we have appraised. It means that the seller has a realistic view of value, and the investment banker doesn’t have to spend time figuring out value (most vastly prefer to be in the market sealing the deal). Also, it sets a bar for incentive compensation (e.g. the banker gets a 10 percent performance bonus if they sell the business for 25 percent over the appraised value).
Investment bankers tend to follow the mantra that a business is worth what someone else is willing to pay for it. I can easily counter this argument with a simple example: if someone is willing to pay $1 for your business, does that mean it’s worth $1, and you should sell? Warren Buffet’s quote is more insightful: “Price is what you pay [or receive]—value is what you get [or sell].”
Investment bankers tend to follow the mantra that a business is worth what someone else is willing to pay for it.
Tina: If I also own the real estate, is it necessary to have my business and real estate appraised separately?
Michael: Again, it’s not necessary to have business and real estate appraised separately, but it’s a good idea. Real estate valuation and business valuation are separate disciplines, and few individuals are qualified to perform both. Personally, I’m not even very good at Monopoly. Real estate appraisals are generally so inexpensive relative to business appraisals that’s impossible to understand why you wouldn’t commission the real estate appraisal if you’ve already decided to proceed with the business appraisal. It’s not terribly uncommon for the real estate to be the most valuable component of the business. Accordingly, not having the real estate appraised leaves the client exposed to a significant blind spot relative to value.
Tina: If I am thinking about exiting my business, what are my options?
Michael: Your options for exiting a business may depend on the nature of the business itself as well as the owner’s personal circumstances:
If you have family members that could conceivably take over the business, the exit may, in fact, be a succession plan.
You may have a buy-sell agreement in place with business partners; simply execute the buy-sell agreement (if it’s written well enough and sufficient funds are available to execute feasibly).
You can put the business on the market. Chances are competitors, or potentially suppliers or customers, would have an interest in buying your business. If the business is large and profitable enough, private equity buyers are always on the hunt for businesses.
Investment bankers can add value to the selling process. They know how to make a market and create an auction for the business. Unless you have very obvious buyers, most investment bankers easily earn their fees.
Employee stock ownership plans (ESOPs) are gaining increased attention of late. They are expensive to implement and maintain, but they can generate the most attractive exits for owners in certain cases. Setting up an ESOP involves selling all or part of the business’s stock into a trust. That trust is a pension instrument managed by an independent trustee on behalf of the company’s employees. ESOPs seem particularly attractive to engineering and architecture firms.
Tina: What are your comments regarding the language in buy-sell agreements pertaining to the value of the business or getting the business appraised in the future in the event of a potential issue?
Michael: Christopher Mercer wrote a terrific book (Buy Sell Agreements for Closely Held and Family Business Owners) on this subject, and many of my views are either directly parroted from or inspired by his writings. Formulas and preset buy-sell values are doomed to create conflict because one party will feel like the loser in the transaction. The fair value of the business or business interest is going to deviate from the formula or set number in a way that benefits the buyer or seller disproportionately. Formulas and set values can also encourage the benefiting party to manipulate a trigger of the buy-sell agreement. The party on the losing end will almost certainly consult an attorney to fight the agreement. At that point, the buy-sell agreement has failed to achieve its objective of an orderly exit transaction.
Mercer suggests listing a group of appraisal firms in the buy-sell agreement that will be asked to bid on the appraisal engagement and carefully detailing the parameters of the appraisal when called upon, effectively writing the engagement letter in advance.
I also strongly agree with Mercer’s idea of using one appraiser. Dueling appraisers more often than not just spend more money on the way to the courthouse or the arbitration room. Hire one appraiser off the list (even the lowest bidder if you need to, as long as you have one objective selection criteria from the group) and live with the outcome. I have published an article on suggested language for buy-sell agreements to make them more comprehensive and enforceable.
If a broken clock is right twice a day, a valuation formula or fixed number is almost certainly right far less often, if ever.
The fair value of the business or business interest is going to deviate from the formula or set number in a way that benefits the buyer or seller disproportionately.
Q: When does a business need a buy-sell agreement? Is this a common issue you encounter? If so, what advice do you have for business owners?
Michael: A business needs a buy-sell agreement at the outset of the venture. The longer you wait, the harder it will be to put in place.
We do encounter buy-sell agreement issues frequently. I’m sad to say that we usually encounter the issue in litigation, and we are asked to serve either as an expert witness or an arbiter.
You should put the buy-sell in place when everyone is still friendly, and everyone has a positive outlook on the business and each other. It’s important to be thoughtful and thorough in the buy-sell agreement by thinking of as many contingencies as possible. Most people consider the triggers of death, disability, and divorce when writing a buy-sell agreement, but what about other instances? For example, what if a partner suddenly decides he doesn’t want to work anymore? How do you define that? Will he be paid the full fair value of his shares, or will the value be discounted? As another example, let’s say one of your partners is sentenced to jail time. Will he be paid the full fair value of his shares, or will the price be discounted from fair value? What if a partner causes the company to be sued?
Tina: When should I plan to begin the succession planning process?
Michael: The answer as to when to begin the succession planning process varies case to case, but one answer that fits everyone is “long before you ever think you’ll need it.” I, and most experts I have heard, recommend at least 5 years before the planned exit. Even 10 years in advance isn’t necessarily too far ahead.
The answer as to when to begin the succession planning process varies case to case, but one answer that fits everyone is “long before you ever think you’ll need it.
Tina: Is there a right or wrong time to have my business appraised?
Michael: Businesses can be appraised at wrong times. The most obvious wrong times are after a critical event, when the information produced can’t help you, or right before one, when there isn’t sufficient time to produce a credible appraisal.
I also discourage startup entrepreneurs from commissioning an appraisal for transaction purposes. There’s not an angel investor anywhere that cares what I think an early stage venture is worth, unless I’m going to be the lead investor (and of course then I’m conflicted). It’s a waste of precious cash, and it shows the investor that you tend to be the kind of person who “lawyers up.” Also, it calls your business judgment into question. The last thing I want to do is hurt a client with my work, and that’s what appraising a startup for capital raising purposes will do in many circumstances.
Also, an appraisal in a buy-sell scenario (with or without an agreement) may not make sense unless the other party agrees (or is legally committed) to be bound by the result. If you want to commission an appraisal for your private planning purposes, then by all means, do so, and that may be a great idea. But expecting the other party to simply capitulate in the face of an appraisal you paid for is simply not realistic, especially when the other party’s input was not sought.
Tina: Why does it cost so much to have my business appraised? Why does it take so long? What are the benefits of having my business appraised?
Michael: The expertise required to perform a business appraisal credibly takes years to acquire, and thus it is expensive to hire, train and retain staff with the skills, expertise and intelligence necessary to carry out the engagements. Our practice, as is the case with most strong practices, also invests heavily in ongoing professional education, as well as tens of thousands of dollars each year for proprietary data sources. In that context, I would argue that a business appraisal isn’t all that expensive. Just gaining access to the data that we use would likely cost the client as much as or more than the appraisal.
The expense also involves the time required to produce a credible appraisal in accordance with professional standards. Most of our engagements require 40-60 hours of professional time to execute, which involves collecting information, data entry, reviewing of documentation, interviews and (sometimes) site visits, independent research, analysis, report production, review, and quality control.
Ultimately, if a client thinks that a business appraisal is expensive, it means we haven’t successfully articulated the value that the engagement will bring to the client.
I do think our profession often takes too many liberties in terms of delivering work products to clients. Our practice does a great deal of transaction work, and you can’t take 4-6 weeks to perform an appraisal when there is a transaction being contemplated. As the saying goes, “time kills all deals,” and the business appraisal firm’s timetable mustn’t be the deal killer. That’s why one of our key performance indicators for our practice is time to delivery—we call it “engagement velocity.” We deliver our initial findings generally within 2-3 weeks of receipt of information from the client and have been much faster. For example, we recently completed an assignment in 3 days for a client with a very urgent need. We might well have saved his job. We were able to do that because we work hard on process, we have a great team that takes client goals personally, and we have a culture of urgency.
The key benefit of having your business appraised is business intelligence. An appraisal performed well should teach the client something (I would argue it should teach the client a lot) that he or she didn’t know at the start of the assignment. That education will enable you to secure a better deal, to recognize and accept a good deal, to avoid wasting time on deals that are non-starters, to manage a business dispute, to think in a factual way about building value in a business, and to manage a compliance process with minimal time and frustration. The educational component is particularly critical to sellers. Many buyers buy businesses for a living. They make 5-10 deals a year and perhaps have been in that business for 20 years. Most sellers sell their businesses once; they are at a tremendous experiential and informational disadvantage relative to the buyer and are taking a knife to a gunfight. An appraisal evens the playing field significantly.
The key benefit of having your business appraised is business intelligence.
Tina: Do you have any other tips or advice for anyone buying, selling, or appraising a business?
Michael: When buying, selling, or appraising a business, let the facts take you where they lead you. An appraisal, properly performed, tests a hypothesis, and the scientific method has something to contribute to the discussion. A good appraiser gathers facts and theories, assesses those facts and theories in the context of the laws of economics and financial markets, and creates a construct (model) to test the hypothesis. In certain professional standards (such as those espoused by the Institute of Business Appraisers), the appraisal should even be replicable by a third-party appraiser. An appraisal that is influenced to produce a particular result (either through pressure, limitation of scope, or concealment of facts) is worthless.
Tina: How can I manage the costs of an appraisal?
Michael: Explaining the intended use and audience of the appraisal to your potential appraiser is critical to managing costs. For example, if you, the client, are the only intended user of the appraisal, then a Restricted Use Appraisal Report may be appropriate to your needs. The appraiser puts in the same rigor as with a formal Appraisal Report, but the report itself is reduced to a summary and spreadsheets. This type of report may be perfectly fine for your needs, particularly in a transaction if you simply plan to use the work product as information to help you assess offers and negotiate. A Restricted Use Appraisal Report takes significantly less time than an Appraisal Report to produce and thus will be cheaper.
Perhaps you don’t need an appraisal at all, but rather some research on discount rates or market comparables so that you can perform your own analysis. In that case, you just need some valuation consulting, and that can be much cheaper than an appraisal.
Rather than commission an appraisal study, you may find it to your benefit to engage a third-party appraisal review of an appraisal. For example, if you are in a buy-sell situation and your partner presents you with an appraisal he or she commissioned which argues the buy-sell price to be paid, you may choose to have that appraisal reviewed before deciding whether engaging a second appraisal is appropriate. If you are commissioning an appraisal and are considering whether redundant appraisals should be performed, consider commissioning a single appraisal instead, followed by a review. An appraisal review requires a fraction of the time and fees of that of a formal appraisal.