Tina: How many years of financial data do you need to appraise my business?
Michael: We usually ask for at least 5 years of historical financial data. However, sometimes a business may not have been in business for 5 years. In that case we would ask for all financial data since inception as well as financial projections for the next 5 years as a valuation of a start-up or early stage company usually cannot be based upon the first few years of a company's existence. In other cases, 5 years may not be enough to represent a normal operating cycle for a business. Construction companies come to mind if you consider the great recession and the number of years it has taken for the construction industry to rebound. So you may need to go back as much as 10 years in order to develop a normalized cash flow for a particular company. As we like to say in the business valuation profession, it is a facts and circumstances driven decision of the particular assignment.
Tina: Can you value my business based on my tax returns and not the financial statements? Is there a benefit to basing the valuation on one vs. the other?
Michael: Very often small companies do not have financial statements prepared by an outside certified public accounting firm. This does not mean that a business valuation based upon tax return data will be flawed in any way. The issue will be whether the tax returns, while prepared on a tax basis, are reflective of generally accepted accounting principles (GAAP). It is also normal for a business valuator to make what we call normalizing adjustments to adjust the presented tax based financial data for such things as accelerated depreciation allowed for tax purposes but not necessarily reflective of GAAP. Valuators face this issue all the time and are experienced in recognizing and adjusting for these types of issues, which could also include tax motivated items such as the amount of reported owner/employee compensation paid versus dividends declared and paid.
Tina: Do assets need to be on my balance sheet to impact my valuation, or do intangible assets not listed on my balance sheet positively impact the value of my company?
Michael: No. In fact, internally generated intangible assets, such as goodwill, are not usually recorded on a company's balance sheet. However, the fact that a company has built-up goodwill as the result of established profitable operations or developed other intangible assets such as trade names, trademarks, secret formulas, patents, etc., will definitely factor into the determination of the value of that company. Intangible assets that are acquired by a company will appear on the balance sheet based upon the acquisition cost, but any intangible assets owned by a company will always be considered in the business valuation whether it appears on the balance or not.
The fact that a company has built-up goodwill as the result of established profitable operations or developed other intangible assets such as trade names, trademarks, secret formulas, patents, etc., will definitely factor into the determination of the value of that company.
Tina: Are valuation guidelines consistent for all business appraisals performed for tax purposes?
Michael: Generally speaking the answer is yes. The valuation of a business interest for tax purposes starts with Revenue Ruling 59-60. While applying the principles outlined in Rev. Rul. 59-60 to all tax valuations is appropriate, differences do immerge in the application of valuation discounts depending on the purpose of the valuation. For example; valuation discounts are always considered for a valuation for estate and gift tax purposes, but a valuation performed for a regular C Corporation for a Subchapter S corporation election would not be considered.
Tina: Will my valuation differ depending on whether I use cash vs. accrual accounting?
Michael: The answer to this question is no because a business valuator wants to begin with accrual basis financial statements. Many times a business valuator is faced with companies that only prepare cash basis financial statements and tax returns. In this case, our first option is to convert the cash basis financial information into accrual basis. If this is not possible due to the lack of available accrual basis information, we would then attempt to assess the impact of using cash basis financials versus accrual basis. The difference may not be significant for income statement purposes for an established business, but for an asset based approach the differences could be significant. For example, a cash basis balance sheet will not contain certain assets like accounts receivable and prepaid expenses and liabilities such as accounts payable and accrued expenses. If the valuator determines that the best indication of value for a particular company is an income approach which results in a valuation that would include all balance sheet items, then using cash basis versus accrual basis may not have a significant impact on the conclusion of value. However, we always attempt to obtain at least good estimates if not the exact accrual basis financial information in order to be sure we have considered all variables in our valuation conclusion.
Tina: What is the difference between seasonality and cyclicality?
Michael: The dictionary definition of these terms is easily applied to businesses. Seasonality in business operations reflects the regular and predictable changes that recur within every calendar year. A simple example is ice cream trucks. In the Northeast, they are not going to sell ice cream from their trucks in the snow. Clearly all of those businesses' revenues are going to come in the summer time. The retail industry is another good example where a disproportionate percentage of their sales come during the holiday season. Cyclicality in business can be defined as a company's sales and earnings that fluctuate with variations in the economy. During the great recession of 2008/2009 a lot of industries were negatively affected, but some more than others. In performing a business valuation, the seasonality and/or the cyclicality of the target company must be considered and evaluated, especially when reviewing the company's historical financial data.
Tina: How does the seasonality of my business affect my business appraisal?
Michael: The seasonality of a business should not affect the conclusion of value if properly considered. Some difficulty could arise, however, if the valuation date is not as of the end of the company's fiscal year. In those cases, the business valuator must annualize the interim operating results in order to evaluate the most current trend in the company's operations. In addition, as a seasonal business, the annualized interim operating results will be based upon historical seasonal statistics. In our experiences, we have found that all seasonal businesses have statistics that help us to properly annualize interim financial data.
The seasonality of a business should not affect the conclusion of value if properly considered.
Tina: How does the cyclicality of my business affect my business appraisal?
Michael: The cyclicality of a business and/or industry is a much more difficult issue to deal with. To be in a position to make the most informed assumptions about a particular company, a great deal of historical financial data may be required over an extended period of years in order to observe how a company is affected by economic, weather, and/or terrorist related events. A business valuator must evaluate, in both upturns and downturns, how a company was affected and how long it took for the business to bounce back or experience a downturn after a cyclical expansion.
Tina: What types of businesses tend to sell the easiest and have the highest valuations?
Michael: The technical answer to this question is that companies with the best free cash flow tend to sell the easiest. I would also like to be able to say that valuations are based entirely on cash flow, but that is not always the case. Certain industries have star power. They are sexier than others. Take owning a sports franchise for instance. Those valuations are sometimes out of sight and do not reflect an investment buyer's expected rate of return. Take a look at the price paid for the LA Clippers. You have to make some very optimistic assumptions about the next TV contract to come even close to the price paid for that basketball team. Clearly, the buyer is not looking for current cash flow!
Tina: What types of businesses are hard to sell and have low valuations?
Michael: The hard to sell companies are those with little to no cash flow. Capital intensive businesses are also very difficult to sell because they require a higher amount of invested capital and banks are not lending money to companies without strong historical cash flows and adequate collateral. That being said, sometimes a small company will sell to someone who wants out of his job at a big company so he/she can be the boss and master of their universe or are just out of work. We call that buying a job. People will buy a company at some price if it will provide them with employment. These valuations are not based upon the financial fundamentals of the business. They are driven by the intangible reasons people want to be in business for themselves. Service type businesses and franchises fit more into this category rather than capital intensive manufacturing businesses.
The hard to sell companies are those with little to no cash flow.
Tina: Do you have any other tips of advice for anyone buying, selling or appraising a business?
Michael: If you are a buyer, make sure you know the idiosyncrasies of the industry you are getting into. If this is a new industry for you, make sure you factor into your required cash needs the learning curve. Also, do your due diligence and assemble a professional team, both financial and legal, to help you evaluate the target company. Lastly, do not invest money you cannot afford to lose. The last statistics I read indicated that there is a general 25% failure rate in small businesses and much higher in certain businesses like restaurants! If you are planning to sell your business, run it like a business not like a hobby. Make sure it is saleable without your day-to-day presence and make sure the financials can withstand an audit and the due diligence a smart buyer is going to perform. This means you may have to pay some more income taxes for a few years prior to sale, but it will pay off in the exit price!