Business Valuation Checklist: 4 Questions to Ask First

Jacob Orosz headshot
by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

Getting divorced? Going bankrupt? Seeking a loan? Getting sued? Planning to sell your company?

At some point, an event will likely occur during the time you own your business that will trigger the need for a business appraisal. Once you determine you need an appraisal, there are several important questions to ask yourself:

  1. Why is this being valued?
  2. When do I need it valued?
  3. What exactly is being valued?
  4. What type of appraisal do I need?

The fact is all appraisals are not created equal.

Valuations prepared for legal purposes — such as taxes, legal disputes, and damage cases — are affected by a complex array of federal and state laws and legal precedents, which rarely impact the value of a business for M&A transactions in the real world.

We can’t save your marriage, but we can point you in the right direction when it comes to getting your business appraised in preparation for a sale. In the article that follows, we take an in-depth look at each of the questions above.

#1 — Why am I Getting my Business Valued?

The purpose determines the methods

The first step before having your business appraised is to determine why you need a valuation for your business. The purpose of your valuation will determine the methods used to appraise your business and the type of appraisal you need.

For example, a business owner going through a divorce who needs an appraisal to calculate alimony payments may require a different standard of value than an appraisal used to resolve shareholder disputes.

A business owner seeking to sell their business will require an appraisal that will use different methods than a business owner seeking a valuation for estate planning purposes.

Purposes & state laws

State laws vary greatly for certain types of business appraisals, such as for divorce, which will have an impact on the type of appraisal you need and perhaps even its value.

Valuations prepared for legal purposes, such as taxes, legal disputes, and damage cases, are affected by a complex array of federal and state laws and legal precedents, which rarely impact the value of a business for M&A transactions in the real world.

Purpose and standard of value

Determining the purpose of your valuation will mandate the standard of value that will be used when valuing your business. Fair Market Value (FMV) is the most common standard of value and is defined as follows:

Fair Market Value: the price at which the property would be bought and sold when neither the buyer nor the seller is under compulsion to buy, and when both parties have reasonable knowledge of relevant facts concerning the business.

A less common standard of value is “investment value,” which is the value of a business to a specific buyer. This type of standard will often yield a higher value than fair market value and is most applicable in M&A transactions.

Most appraisals are valid for only one purpose

The purpose of the valuation is an important consideration in the valuation process and must be carefully considered before the appraisal process begins. Business appraisals are rarely applicable for more than one purpose.

For example, if you had your business valued for the purpose of a divorce, the final value may not be relevant if you are looking to establish a price to sell your business or for estate planning.

#2 — When Do I Need My Business Appraised?

Changes in the future can cause differences in the valuation

For appraisals required for legal purposes, the date of the valuation is crucial because circumstances in the future can change and, therefore, cause major differences in the valuation.

It’s simplest to value a business at the end of its fiscal year

This is because adjustments often have to be made depending on the date of the appraisal, such as different accounts receivable, different levels of inventory, and so forth. However, it’s not always possible for a business owner to wait until the end of the fiscal year to obtain an appraisal.

The date is critical when seeking a valuation for legal purposes

In these cases, the date is usually subject to intense negotiation, except for cases in which it’s outside of the parties’ decisions (i.e., taxes). Changes in the date of an appraisal can be costly and can require a new business appraisal to be performed.

The valuation can be adjusted with metrics over time

When selling a business, metrics can sometimes be established, such as a defined multiple of EBITDA, which would allow the parties to adjust the valuation over time, assuming there are few other meaningful changes in the business, its industry, or the economy as a whole.

If the parties agree on the metric, they can apply the metric (multiple of EBITDA, SDE, etc.) to the base value (revenue, EBITDA, cash flow, etc.) to establish a value for the business and then make minor adjustments to the price to account for any other factors that may have changed since the appraisal date.

Consider the lead time

When having your business valued, you also need to consider how long it will take the business appraiser to prepare the valuation. A lead time of 30-60 days is often required for an appraisal for a small or medium-sized company. For companies in the process of selling, a lead time of two to four weeks is often sufficient.

#3 — What is Being Valued?

Finally, you should ask yourself: What am I valuing?

You should have a clear understanding of what asset, property, or business interest needs to be valued.

What follows is a description of how different interests, or tangible and intangible assets, are treated when valuing your business:

Assets

Most transactions in the lower middle market are structured as an asset sale rather than a stock sale. If your transaction is structured as an asset sale, you will need to determine what specific assets will be included in the sale before valuing your business. Another factor that must be taken into consideration is whether any of the assets are leased and whether the lease will be paid off at the time of closing. These are the assets that are typically included in a sale:

  • Tangible assets such as furniture, fixtures, equipment, and leasehold improvements.
  • Intangible assets such as goodwill, customer lists, patents, copyrights, trade secrets, websites, phone numbers, and business names.

Stock

If your stock is being valued, you will need to determine if there are any restrictions on transfer that could impact the value. If a partial ownership interest is being valued, then the relationship to the other ownership interests must also be examined. For example, a stock that represents a swing vote may be worth more than its pro-rata share of the business.

Non-compete or employment agreements

You should determine whether non-compete and employment agreements will be valued separately or if they will be included in the bundle of assets being valued.

Real estate

If you are obtaining a valuation as you prepare to sell your business, you will need to determine whether the real estate will be included in your sale. Real estate is often valued separately, preferably by a certified commercial real estate appraiser who is familiar with your local market area. Adjustments must also be made to the financial statements if your business is not paying your real estate entity a rental amount based on current market conditions.

Debts and liabilities

Most businesses are valued without taking into consideration their debt and liabilities. In other words, the valuation assumes the assets are debt-free for purposes of the appraisal. If your business has any outstanding debt or other liabilities, these must be subtracted from the appraised value when calculating your net proceeds.

Contracts

Contracts are at the heart of almost every business. You should assess what contracts you have, such as employment contracts, customer contracts, equipment contracts, and leases, and if those contracts are assignable.

#4 — What Types of Appraisal do I Need?

When considering whether you should have your business appraised, you have several options. Valuations do not have universally standard definitions, but most fall into three main categories: a verbal opinion, a written report for non-legal purposes (such as a business sale), and a written report for legal purposes.

Verbal opinion of value

A verbal (technically “oral”) opinion of value is suitable for any business owner who doesn’t need a formal report. This report usually involves the appraiser, broker, or CPA reviewing the owner’s financial statements and then offering a verbal estimate of value. Some business brokers and M&A intermediaries will not charge for a verbal opinion of value. However, you should question the value of an expert’s opinion if they are willing to provide it for free. These types of reports are useful if you are in the exploratory stages of selling a business and prefer a ballpark idea of what your business may be worth before committing more time, money, and effort to the process.

Written report, not complying with appraisal standards (Restricted Appraisal Report)

Written reports can range from a couple of pages to 50 or more pages. These reports do not comply with appraisal standards and cannot be used for legal purposes. We generally refer to these reports as a “business valuation, not for legal purposes.” The format of these reports varies considerably. Some are simple and straightforward, and others are long, formal, and full of technical jargon that has little basis outside of the legal world. A “calculation of value” is the industry’s attempt to offer a simplified report for business owners. Pricing can range from free to tens of thousands of dollars. These reports are useful for business owners looking to sell a business. Because these reports do not comply with appraisal standards, the format of these reports varies. Categorizing the types of reports found in this category is nearly impossible.

Formal appraisal (self-contained)

This type of report is required for any legal purpose, such as divorce, tax matters, or bankruptcy. These reports are often hundreds of pages in length and are of little use to a business owner looking to sell a business. The format of these reports is more consistent than a Restricted Appraisal Report because they must comply with the appraisal and legal standards. However, they are of little help to business owners who need a valuation for planning the sale of their business. These reports typically cost $5,000 or more.

Conclusion

When having your business valued or appraised, it’s important to remember that all valuations are subjective. There is no exact formula that will yield a precise number.

Before having your business appraised, you should ask yourself the following questions:

  1. Why is this being valued?
  2. When do I need it valued?
  3. What exactly is being valued?
  4. What type of appraisal do I need?

Asking yourself these questions will help ensure you obtain the right appraisal for your specific situation. Before hiring a business appraiser, make sure you have a clearly defined purpose and know exactly when you need the appraisal completed. While a business appraiser can help you determine these, it will save you time and money if you have a good understanding early on of the types of valuations and the process.