A third-party appraisal is just that — an appraisal performed by a third party. You pay the broker directly, and they subcontract out your business appraisal to a third-party appraiser, whom you never meet.
Larger offices refer appraisals to a third party and mark up the cost by 100% to 500%. This is in addition to other fees they may charge you to sell your business. In the office I worked in prior to starting Morgan & Westfield, we charged $4,950 for a third-party appraisal that cost us approximately $750. That’s a 660% markup.
The fundamental premise that proponents of third-party appraisals advocate is that a third party is unbiased and the valuation is, therefore, more likely to be trusted by a buyer.
Is the appraiser truly unbiased? Is a third-party business appraisal necessary when selling your business? Why don’t brokers just perform the valuation in-house? Why do they feel the need for a third party to perform the valuation? If you pay for a third-party appraisal, can you talk to the appraiser directly or do you only communicate with the broker? These are common and complicated questions.
Valuation is a complex science and requires years of experience to master. Most offices have high turnover and this requires that they outsource the technical processes, such as valuations or appraisals, since it’s unlikely that new hires will have these skills or knowledge.
Outsourcing this process is simpler and limits the amount of training the office has to provide to its agents. Acquiring the knowledge to properly prepare a business appraisal takes years and in-depth knowledge of dozens of fields. Due to how most business brokers’ agreements are designed, their fee structure, and how their office is structured, it makes sense to outsource the appraisal.
Should you consider a third-party appraisal when selling your business? Do these appraisals eliminate conflicts of interest?
This article explains.
Table of Contents
- Why Don’t Brokers Perform Appraisals In-House?
- Why Do Firms Offer Third-Party Business Appraisals?
- Do Third-Party Appraisals Eliminate Conflicts of Interest?
- The Major Downsides to Third-Party Appraisals
- Take Control of the Process & Get Your Questions Addressed
- You Deserve an Honest Relationship
- Appraisers Depend on Volume
- What Are You Paying For?
- Experience Makes a Difference
- The Difference Between Using Standardized Reports and a Customized Approach
- Are Third-Party Appraisers Really Unbiased?
- Is it True There is a Correlation Between Businesses That Have Been Appraised and the Percentage of Asking Price Received?
Why Do Firms Offer Third-Party Business Appraisals?
The answer is simple: It’s good for business and good for them. Most offices have high turnover and this requires that they outsource the technical processes, such as valuations or appraisals, since it’s unlikely that new hires will have these skills or knowledge. If they did have these skills, it’s unlikely they would join an office in the first place since they would probably strike out on their own.
Third-party appraisals are beneficial for only one party — the broker. As a broker, since you are not doing the appraisal yourself, you need absolutely no appraisal experience to sell an appraisal to a client. You can sell them to clients at a markup of five to 10 times the cost. So, if the appraisal costs you $750, you can sell it for $3,500 to $7,500. A business broker can get started today, with no industry experience or investment, and immediately start selling third-party appraisals to unsuspecting clients at a high markup.
A broker who owns a business brokerage office has it even better. They can hire new associates who have zero experience or knowledge, and have them also start selling business appraisals. There is no need to train the brokers. They can hire anyone, no matter their background. By selling a third-party appraisal, a broker needs no specialized knowledge, experience, or certification, and neither do their associates.
The ability to outsource the technical processes lowers the bar (i.e., barriers to entry) and makes it easier to sell business broker franchises, or to bring new brokers onboard. After all, it’s much easier to hire new brokers or sell a franchise if the requirements for entry are lower.
The moral of this story is: Don’t work with a broker if they don’t have the knowledge to value your business.
Why not just hire the appraiser directly at 10% to 20% of the cost? The next time a broker recommends a third-party appraisal, ask the name of the company they use. Then ask if they can put you directly in contact with the appraiser. They may respond by claiming that the appraiser only works through brokers. That’s a cover-up — it’s unlikely the appraiser works only through brokers. Then, ask the broker what their markup is, if any. There should be no reason for a broker to hide the amount of their markup. If they do attempt to hide their cost, and if the broker you are talking to can’t be transparent, we shouldn’t have to tell you this, but: Look elsewhere.
On a side note, marking up “managed services” is a reasonable practice, as in the case of attorneys who may outsource some of their services to third parties. But, in these cases, the managing party discloses such a relationship and also provides value in managing the services, which justifies the amount of the markup. As an example, many attorneys outsource transcription, research, collection, and filing services, and then charge clients a markup for managing these services. Such a fee is reasonable, but two things should be present: 1) disclosure, and 2) value for the fee that is being charged.
Do Third-Party Appraisals Eliminate Conflicts of Interest?
Is it a conflict of interest if a broker prepares a valuation for a business that they are selling? Is it best to hire an independent, neutral, third party to appraise your business if you are considering selling it?
Yes, it is a conflict of interest when business appraisers depend on referrals from brokers.
If it truly was best to hire an independent party, then no broker should ever provide an opinion of value — this goes for residential real estate agents, commercial real estate agents, fine art brokers, yacht brokers, and any other broker. Who would you rather hire to value your fine art collection: Someone who sells fine art, or someone who sits in an office in front of a computer who has never sold a piece of art in their life?
If you used the “neutral, independent, third party” argument, then by definition, you would preclude the experts in the best position to provide an opinion — the people who function as dealmakers in the real-world marketplace. Who else would best know the actual values of businesses that are selling?
There is a blatant conflict of interest if a broker recommends a specific third party to evaluate your business while simultaneously receiving a referral fee for sending you to that third-party appraiser. In these situations, brokers send you to appraisers in their network and receive compensation from the appraiser for the referral. Then, they mark up the cost of the assessment that you pay, and they make money from both of you.
To be clear, there are honest brokers out there and, if you are savvy in your interactions with them, you can learn ways to spot them among the untrustworthy ones. An honest professional will provide you with a list of several appraisers and tell you to contact, hire, and pay one directly.
The Major Downsides to Third-Party Appraisals
The primary downside is that the business owner rarely has the ability to communicate with the appraiser directly. In essence, the owner will receive a number (i.e., what the appraiser thinks the business is worth) in a black box with no justification or explanation. Yes, there is an accompanying written report, but few business owners can read and understand the contents of the report, and few brokers who sell the reports possess the experience and knowledge to be able to concisely explain the appraiser’s reasoning. Most experienced brokers don’t sell third-party valuations. This means that, by default, the primary group of brokers selling third-party reports are inexperienced and therefore lack the knowledge necessary to cogently explain the details of the report to the business owner.
The appraiser is typically out of state and has no experience selling businesses — their only specialty is appraising businesses. The appraiser also spends little time getting to know a business and its strengths and opportunities, so the definition of value will usually be limited to fair market value (FMV). Often, the broker can’t explain the methods used by the appraiser to value the business because they either don’t know or they lack the knowledge to understand the reasoning behind the methods. When I sold third-party valuations over a decade ago (don’t worry, I have since learned from my mistakes), I rarely communicated with the appraiser. Not only was the owner receiving a number in a black box, but unfortunately, I was as well. When asked to explain what was in the black box, I had a difficult time — because I didn’t know what was in the black box either.
If I did communicate with the appraiser, I received a terse response at best. The business owners weren’t thrilled with the disconnect in communication and neither was I. Today, most of my conversations on valuation with a business owner are highly complex as we quickly weave through dozens of interrelated factors that may impact the value of their business. Such a linear back-and-forth relay of messages simply doesn’t work for a complex multi-variable topic such as the potential value of a small to mid-sized business.
If you are looking for a number in a black box, with no further explanation, then such a solution may suit you well. However, if you want to know why your business is worth a certain amount, the factors that affect its value, and what you can do to improve its value, a third-party appraisal is unlikely to provide answers to those questions. In other words, any meaningful questions about the appraisal are likely to go unanswered.
The same problem applies for buyers. What happens if a buyer has questions regarding the appraisal, such as “Why was a 3.5 multiple used? I heard multiples in the industry are 2.5 to 3.0.” Buyers likely won’t be able to communicate with the appraiser directly. Even if they could, the appraiser has a tenuous understanding of the business, at best, and this lack of understanding is unlikely to instill trust on the part of the buyer. The buyer will therefore be less likely to trust the appraisal.
Take Control of the Process & Get Your Questions Addressed
Do you really want an appraiser valuing your business who never interacts with you, and who knows nothing about your business other than seeing your financial statements? What if you have questions regarding the appraisal? The ideal person to answer your questions should be the appraiser who prepared the report, not a broker who lacks appraisal experience.
The industry standard that focuses on the benefits of appraisals to brokers, rather than the benefits of appraisals to the business sellers, is a backward perspective. The client’s interests should be put first — not the broker’s. Potential clients at traditional brokerage firms are often given a false narrative about the costs and processes of appraising a business in an attempt to justify the advantages of using a third party. This narrative often covers up a broker’s true interest, which is marking up the cost of the appraisal five to 10 times, and then pocketing the difference.
To be clear, I despise castigating others in our industry, but this practice is downright dishonest and needs to stop. So, I have no qualms about knocking this industry-wide practice, especially if it’s in the client’s best interests.
You Deserve an Honest Relationship
Your business is one of your most valuable assets, and you should trust and respect your broker. Are you really going to trust a broker who marks up a third-party service five to 10 times while providing little to no value? Marking up some third-party services is common in certain sectors, such as the legal field. However, these markups often range from 10% to 50%, not 500% to 1,000%. And value should be provided.
If the service is simply managed from an administrative point of view, then perhaps a 10% to 20% markup is justified. If value is added, such as the case in a “value-added reseller” (VAR), then perhaps a 50%-plus markup may be reasonable. Regardless, markups should be disclosed. If the broker attempts to hide the amount of the markup, they are being dishonest. And if the broker can’t be transparent, then you shouldn’t trust them to handle the most important transaction of your life.
Appraisers Depend on Volume
About a dozen years ago, I called an appraiser I was working with to question one of their methods. The appraiser was busy, so he simply changed the report to get rid of me. No conversation was needed, as far as he saw it. This was a well-known, national appraiser, regularly used by large business broker networks. The company I worked with sent them a lot of business. All this appraiser did was make a couple of tweaks to increase the value of the company in the appraisal, just to keep me happy.
Why did he have to get rid of my concern? Because their business depends on volume. They likely perform thousands of appraisals per year, at a low cost, and they simply don’t have the time for in-depth conversations about their appraisal methods.
If you are talking to a broker, and they recommend a third-party appraisal, I recommend you look for another broker. If you insist on continuing the conversation, then ask the broker:
- What is the name of the firm you use?
- Do you mark up the cost of the appraisal?
- How much do you mark up the appraisal?
- Can I hire the appraiser directly?
- Can I talk to the appraiser directly first, before paying for the appraisal?
- What knowledge or experience do you have preparing business valuations or appraisals?
- Can I talk to the appraiser directly if I have questions?
- Why don’t you prepare valuations yourself?
- What methods does the appraiser use?
- How many years of experience does the appraiser have?
- What certifications does the appraiser have?
- How many businesses has the appraiser sold?
Hopefully, you can see that paying for a third-party appraisal is not a wise choice.
What are You Paying For?
Consider it this way: What are you really paying for? You aren’t paying for just a number. You are paying for the appraiser’s knowledge, experience, and advice. Why is your business worth what it is? What can you do to increase its value? What will the impact be on the valuation of your company if you do x, y, or z?
The most valuable advice I provide to a business owner isn’t the number I give them, it’s the collective wisdom behind why their business is worth what it is, and what they can do to change that number. The advice, in my case, is based on over two decades of experience in the real world of buying and selling businesses, and not in the theoretical world of spreadsheets and shiny ivory towers.
If a broker is attempting to sell you a third-party appraisal, ask the broker if they earn a fee or commission from “referring” the appraiser. You can also ask for the appraiser’s contact information and tell the broker you prefer to hire the appraiser directly. You will likely be told that the appraiser only works on a “wholesale basis” through the broker. Such a response is nonsense.
An appraisal of any worth requires communicating with the business owner. The reality behind why the appraiser won’t work with clients directly has to do with how the appraisals are prepared and the economics of the referral relationship. These appraisals are performed with data entry people entering information into a computer program and, voila — after 30 minutes of data entry, the software spits out a beautiful report that looks as if it took days to create. The longer and more confusing the report the better, since you will be intimidated and less likely to read it and ask questions.
The only way these appraisers can make a decent living is by producing a high volume of these reports with the help of data entry people — much like an assembly line. Unfortunately, people punching numbers into computers sometimes make mistakes. There is also the issue that communicating with the business owner simply requires too much time. So, if time were available, the economics would need to change (i.e., the appraiser would need to charge more than $750 to the broker). In this case, you don’t even get what you pay for. Unfortunately, you get what the broker is paying for, which can be significantly less than what you paid.
Experience Makes a Difference
As a general rule, most brokers who “sell” third-party appraisals are less experienced than those who don’t. It’s a classic situation of selection bias: Why would an experienced expert pay for the advice of another experienced expert who has no practical experience in their field? Answer: They won’t. So, by default, the primary brokers selling third-party appraisals are those who lack the experience to perform an appraisal themselves.
Most experienced brokers prefer to perform their appraisals in-house so they can intelligently discuss the results of the appraisal with the business owner. They are also uncomfortable with marking up a service by 500%. Many have told me they are less than impressed with the quality and relevance of the appraisals they have seen from third-party appraisers.
Relevance is important because most “business appraisals” are performed for legal purposes, such as divorces, tax planning, partner disputes, etc. The methods used to appraise a business in the courtroom are entirely different from those used to appraise a business in the real world. Buyers know this and if they can’t understand the contents of a business appraisal, they are likely to dismiss it.
The software used to value businesses is readily available to the public. I have purchased numerous versions of appraisal software in the past and I have always been disappointed with the results. Most software is designed to appraise businesses for legal purposes and does a poor job of taking into account any factors that aren’t built into the rigid architecture of the software. The ease of producing a lengthy report is seducing, to say the least, but I haven’t been able to overcome the lack of relevance of these reports.
One example would be the question of liquidity ratios — are they really relevant for a small business? Whether they are relevant or not, they are likely included in the options for consideration in standardized reports. The reports are difficult to customize and the software must be designed to accommodate the highest level of complexity the user might encounter.
As a result, you are forced to enter data for dozens of irrelevant fields, which quickly muddies up the report with irrelevant data, drowning out the meaningful information. As a result, the report ends up significantly longer than it needs to be, contains a lot of irrelevant information, and doesn’t account for any factors that the software was not designed to account for.
The Difference Between Using Standardized Reports and a Customized Approach
To provide an example, I just finished an assessment phone call with a potential client who owns a service company in the aerospace industry. During the call, we discussed the factors that can potentially influence the value of his business. This particular business was complex with many interrelated factors that could influence the value. As we peeled the layers of the onion back and dug deeper into the business, our knowledge of the business deepened and our understanding of those factors changed the valuation as the conversation progressed.
During such a call with a potential client, I walk the owner through the impact of the factors on the valuation as we are discussing them. I perform these calls using a simple proprietary spreadsheet in which the client can see the impact of the changes live on their computer screen as we are discussing them and fine-tuning the model. In this situation, we examined who the likely buyer of the company was going to be. Was it likely to be an aircraft maintenance company or more likely to be a company offering the same service but in another industry (i.e., a horizontal acquisition)? As we explored the potential universe of buyers, we examined the impact of the different types of buyers on the financial performance of the business and, therefore, the valuation. This simply can’t be done in a box without input from the owner. And making the changes live allows you to see the impact of the key value drivers on the value of your business.
For example, if the business were sold to a company offering the same service but in another industry, a number of duplicate expenses would likely be eliminated. The cumulative reduction of these expenses ranged from $200,000 to $250,000 per year. This impacted the valuation of the business by a factor of the multiplier — 4.0 — or $800,000 to $1,000,000. However, if we sold the business to an aircraft maintenance company, it’s unlikely the buyer would experience the same reduction in expenses, though they may experience revenue synergies. The revenue synergies were more difficult to calculate, so we reverse-engineered several scenarios and their potential impact on the valuation. The aircraft maintenance company would be introduced to hundreds of new clients and would therefore be able to offer these new clients their suite of aircraft maintenance services. The value of these synergies couldn’t be estimated exactly, but we created a range of assumptions from low to high and examined their impact on the valuation.
This was all within a ten-minute window on our phone call. During the call, we discussed dozens of other factors and their attendant impact on the valuation. Such a call, which we perform during our valuation, is typical for us. For the average client, we examine multiple factors that may have a significant impact on the valuation of their business.
Often, owners are at a crossroads and must make a decision between divergent paths and their resulting decision impacts the valuation. This is precisely why a valuation can’t be performed in a bubble. In my opinion, performing a valuation requires two important elements: 1) real-world experience buying and selling businesses, and 2) input from the owner. Unfortunately, third-party appraisals lack both of these critical elements.
Knowledge of the actual marketplace is instrumental in both assessing the value of the business and in communicating that value to you, the business owner. In most small- to mid-sized businesses, multiple strategies exist to potentially sell a company and the strategy that is employed can have an appreciable effect on the valuation.
Are Third-Party Appraisers Really Unbiased?
Under a third-party appraisal scenario, the broker has an ongoing relationship with the appraiser. What happens if the appraiser undervalues the business? Is the relationship likely to continue between the broker and appraiser? In one case, when I previously sold third-party appraisals over ten years ago, I called the appraiser to ask why they chose a certain multiple for a business they recently appraised. I was shocked when the appraiser simply bumped the multiple up with no questions and re-sent the report to me, ostensibly in an effort to “get rid of me” as quickly as possible.
Is it True There is a Correlation Between Businesses That Have Been Appraised and the Percentage of Asking Price Received?
Some brokers have claimed that, “We receive 97% of the asking price for those businesses that purchased a third-party appraisal,” or “Businesses that pay for a third-party appraisal sell faster.” Yes, it’s possible there is a correlation. But is there causation? Or is it likely that the owners who are willing to pay the money for a third-party appraisal are more serious, or more prepared, or more committed? Or are these businesses just priced more realistically due to the input of the appraiser? If so, could the same results be achieved without the benefits of a third-party appraisal? Is it possible the appraiser is under-valuing the businesses? Regardless, a causation has not been proven and such a claim is dubious, at best.
Our recommendation is to only work with brokers who perform valuations in-house. If a broker does try to sell you a third-party appraisal, then demand to pay and work with the appraiser directly. However, you are still better off obtaining the opinion and advice of an experienced broker. And only pay for advice from someone with real-world experience in the marketplace.
The specific format or type of appraisal is not the most important factor — what matters most is the experience of the individual who is providing you with the advice. And the more experience, the better. As the saying goes, “You get what you pay for. Or, in the case of third-party appraisals, you get what your broker is paying for. You have worked hard to get where you are today. Don’t leave money on the table by outsourcing one of the most important elements of the process to a third party who has no experience in the marketplace and whom you never speak to.