Tina: What are the top mistakes that business owners make when looking to establish a value for their company?
Peter: I work exclusively with closely held and employee owned companies. The most common mistake that these business owners make is in assuming that there is a magic black box that can be used to value their business. The fact is that instead of one process, there are several processes for determining a value. The process chosen by the appraiser depends upon the purpose of the valuation, the date of the valuation, the size of the business, the type of equity being valued and countless other factors. For example, a business owner that needs a valuation for gift tax purposes should not rely upon a valuation conducted when his partner got divorced two years ago. Each individual engagement needs to comply with the processes appropriate for the purpose of the appraisal.
Another mistake, common to small business owners, is that they rely too often on anecdotal information when deciding how much they believe their business is worth. Instead of seeking advice from a professional, they rely on stories from friends and colleagues who recite how much similar businesses may have sold for in the past. While it is useful to have that information, more often than not it doesn’t tell the whole story. For example, I worked with a company that was convinced that their business was worth $1 Million, simply because a competitor that had similar sales revenue sold their business for $1M. When we dug into the details of the sale, the story was quite different as the purchase price included real estate valued at $700,000. Our company did not have dirt to sell, so the value of the company was much less.
Finally, many small business owners run personal/non-operational expenses through their business that reduces profits. For tax purposes, this may help the business owner in the short term, but in the long term, it reduces the value of the business. Business appraisers will add back a number of those expenses when arriving at a value. The better practice, when preparing a business for sale is to run your business as efficiently as possible to present the most accurate picture of your businesses operations.
Tina: Why does it cost so much and take so long to have my business appraised, and what are the benefits?
Peter: As a transactional attorney and business appraiser, I tend to take exception to the premise that appraisals cost “so much,” but I also understand where that idea comes from. It may well be that the cost of an appraisal exceeds a business owner’s expectations, but (at the risk of sounding glib) that is mostly because our industry has done too little to explain the value of our services. Often our clients are focused on extracting a number, and indeed, if all they want is a number, that should not take very long. But the number represented by a conclusion of value is the least significant part of the service that we provide. The greatest value that we provide is in illustrating, clearly, how we arrived at a conclusion of value. When an appraisal is done correctly, the report will show the business owner how efficiently the business is operating, how it compares with its competitors, what other businesses have sold for, how to identify competitive and operational strengths and weaknesses, and how to answer any concerns that a potential buyer might have. Every publicly held company provides this information to its owners, therefore small business owners should have it too.
Appraisers and lawyers get paid for their time and advice, and appraisals take a great deal of time and advice to do correctly. There is no one-stop-shop for business data, no short cut for interviewing key personnel, and no single method for gathering the information necessary to accurately present the financial status of the company. An appraiser must know where to look to obtain usable industry information to compare our company with, they must be knowledgeable enough to identify comparable sale information, public company information and have enough experience to assess the proper discounts for the interest being valued. All of that, if it is being done well, takes time. To prepare a report that communicates that information in a way that is usable to the owner, and will be acceptable by a court, the IRS, or department of labor takes even more time. In my estimation, it is worth paying for an appraisal that does all of those things.
Tina: What are some questions to ask potential business appraisers before hiring one?
Peter: As with hiring any professional, experience is important, and clients should ask about the number and types of appraisals that an appraiser has done. For me, the type of appraisal has more to do with the purpose of the appraisal, and the size of the company, rather than appraisals related to particular industries. It’s not that most qualified appraisers can’t figure out what to do, it is simply that most companies don’t want to pay for an appraiser to learn as they go. Appraisals for ESOP owned companies, for example, or pass-through entities like S Corporations and LLC’s have some special characteristics that, if an appraiser has worked in those areas, you won’t have to pay them for the learning curve.
Business owners should also ask how long it will take to issue a completed report. While each engagement is different, a time frame of three to four weeks after all of the information has been provided to the appraiser is fairly typical. Obviously, cost is an important issue. Business owners should ask, given the purpose of the report, whether a full report is necessary or even advisable. Under some circumstances, an abbreviated report may be called for, and that will necessarily reduce the cost. In fact, sometimes it is best not to have a written report at all. Also, many appraisers will work off a flat fee. This has the added benefit of presenting a known cost, although it may also create an incentive to cut corners if the engagement becomes more complicated than the appraiser originally thought. Again, the experience of the appraiser is obviously important when considering a flat fee.
There is no one-stop-shop for business data, no short cut for interviewing key personnel, and no single method for gathering the information necessary to accurately present the financial status of the company.
Tina: Are valuation guidelines consistent for all business appraisals performed for tax purposes?
Peter: All good answers being with ‘it depends.’ In the case of taxes, it will depend on the taxing authority (federal or state), and the court that might be considering the issue. The IRS has produced guidance for valuation of small businesses through a number of sources (regulations, revenue rulings, etc.), and if all we had to care about was the IRS, things would be fairly consistent. But the IRS is not always the final arbiter of tax issues and courts will often come to different conclusions from the IRS. Sometimes the IRS will acquiesce to those decisions, and sometimes the IRS will disagree with a court’s ruling.
One of the longest running, and most active, areas of divergence between the IRS and courts (and a lot of practitioners) is whether companies that don’t pay tax (S Corporations and partnerships) should be valued as if they do pay tax. Another area of controversy is whether (and how much) of discount equity owners should take when they gift privately held and minority owned equity in companies.
It’s also important to understand that courts in different areas of the country apply different standards as well, so an identical business located in Delaware, for example, might have a different value than a business located in Florida, simply because the courts may view discounts differently. So, while the IRS, courts, and practitioners agree on a number of guidelines, there are too many areas of conflict for me to say that the guidelines are consistent.
Tina: Will you need to perform any forensic accounting when appraising my business?
Peter: I have never had an occasion where forensic accounting was required, though I can imagine in a litigation context a court might order a forensic accounting prior to a valuation. Having audited financial statements is often beneficial, as those numbers are seen to be more reliable than compiled financials, reviewed financials and tax returns. And, while it is not necessary to have audited statements, I believe that third parties view companies with audited statements differently than compiled statements, and I do take that into account when conducting an appraisal.
Tina: When is the best time to sell, merge or recapitalize my company?
Peter: Every business is different, and every business owner is different, which means that the best time to sell is owner dependent. Having said that, the best time to sell is always when you have planned for the transaction and when you are ready. Business owners that recognize the need to plan for the sale of their business are always in the best position to determine when they are ready to sell. More importantly, businesses that have planned for a sale are more likely to sell because they have all of the necessary documents to complete a sales package including accurate financial statements, corporate documents, employment agreements, vendor agreements and an appraisal report to support the sales price.
I worked with a client that wanted me to assess a business for a potential purchase. The financial statements were incomplete, they had an incomplete list of inventory, assets and equipment, no corporate documents, and they still wanted $500,000. From everything presented it appeared to me that this was a fire sale, and in fact, after some digging, I uncovered a recent bankruptcy by the owner. I also found that they had an outdated inventory, and were in a complete mess when it came to operations. When I pressed their CPA, he admitted that creditors were at the door, and they were reacting to that with a desperation sale.
Every business is different, and every business owner is different, which means that the best time to sell is owner dependent.
Tina: Who are PEGs? Does it make sense to sell my business to a PEG?
Peter: PEGs are Private Equity Groups, or in other words, companies that acquire businesses often for the purpose of growing them and selling them for a profit. I don’t do a lot off work with PEGs because they tend to focus on larger companies, but they can be part of a well-crafted succession plan. They often make good buyers, as they usually pay investment value (which is generally higher than fair market value), and they have experience buying and selling businesses; so transactions have a better chance of closing in a reasonable time. In addition, they generally have access to sufficient cash so that bank financing or seller financing is not an issue. And for the groups that may not have cash set aside, they usually have excellent banking relationships so that bank financing is generally not an issue.
For business owners that have a personal attachment to their business, and their employees, PEGs may not be the best buyers, as they usually engage in aggressive restructuring, especially if they already have a footprint in a given industry.
Tina: What are the most common reasons you perform a business valuation?
Peter: I generally perform valuation for one of three purposes. We do appraisals for companies owned by ESOPs. We do valuations for estate planning and gifting for small business owners. Mostly, we do transactional valuations for shareholder buy-outs, buy-sell agreements and buying and selling closely held businesses. There are a whole host of other reasons to have appraisals done, but those are the three we see most.
Tina: In your opinion, what are the minimum credentials that a business appraiser should possess? What additional credentials are valuable? What is the best way to locate a reputable business appraiser?
Peter: I am certified with NACVA. There are other reputable certifying bodies that require a base level of experience, knowledge and continuing education as well. There are a number of appraisers that have credentials from multiple certifying bodies and I am not sure that is necessary. In some limited circumstances that can create issues in deciding which ethical standards to use. Ask the appraiser that you talk to what the requirements were for obtaining the designation(s), and what their continuing education requirements are. By asking the right questions you can get a feel for which designations are a better fit for your business.
Finding qualified appraisers seems less difficult now. I am biased, but for what we do (shareholder issues, ESOPs and estate tax valuations), I think referrals from attorneys are the best way to find reputable appraisers. Accountants are also helpful in identifying qualified appraisers as well. In either case, I think it’s important that you find someone who has worked with the appraiser previously in order to get a real sense of the work that they do.
Lastly, NACVA (and probably all the other bodies as well) provide a list of appraisers with some basic background information. After you have identified two or three, it is usually a good idea to meet with all of them to see who might be the best fit.
The IRS is not always the final arbiter of tax issues and courts will often come to different conclusions from the IRS.
Tina: What was the most challenging appraisal you have ever done? Was there something that the business owner could have done to prevent the problems that arose?
Peter: The single most challenging appraisal was also the most enjoyable, and best illustrates the point I was trying to make earlier about the purpose of the engagement. The engagement started off as an estate planning engagement for a small manufacturing company. During the course of the engagement, after a draft report had been sent, but before issuing the final report, the owners were approached by a third party with a generous offer, which was communicated to our office. Our engagement morphed into assessing the offer made by the third party (which was well in excess of the value arrived at for gift tax purposes). Eventually, when they declined the offer, we went back to completing the gift tax report. The third party offer, however, raised a number of issues for our conclusion of value for gift tax purposes.
Ultimately, because our report addressed (with clear support) why the third party offer did not significantly impact our earlier conclusion of value, we were confident in that value, and our client and their advisors were comfortable as well. I do not believe that the owner could, or should, have done anything differently. While it may have been tempting not to disclose the offer to me as the appraiser, I think it was the correct thing to do. By including the information in our report, in the event of an audit, we have minimized what would otherwise be a large issue if the IRS discovered it on its own, and found it omitted from our report.
Tina: Do you have any other tips of advice for anyone buying, selling or appraising a business?
Peter: Where to start? If you own a business, start planning for the day when you will no longer own the business. One business cycle is not too long to start planning, but three years before you would like to sell should be sufficient. If you are buying a business, figure out what it is that you are buying. If you are buying the future income of the business, figure out where that income is coming from, and decide whether it will transfer to you. If that is assets, or inventory, make sure that the assets are usable, and that the inventory is still good. If it is intellectual property, make sure that you have the right to acquire it. If you are appraising your business, talk with an appraiser about what the purpose of the appraisal is. In addition, learn what the process is. Identify what processes are necessary, useful, and/or unnecessary. Identify the costs for the necessary portions, and decide whether you will get sufficient value to pay for the parts that will be useful.