Those are not the only differences that I must consider as business appraiser.  I have to start out with the basics of valuation – what type of value is necessary for the purpose of the valuation.  Then I have consider the interest being valued – is it a controlling interested or a non-controlling (minority) interest?  All of these factors impact my conclusion of value.

You are a potential client and you call and ask, “Can I use a 1 times revenue to value my business, since that is the industry rule of thumb?” In order to begin considering my answer I need to find out what type of value you are trying to establish, the purpose of the valuation, the interest being valued and information about your company to determine if it is average for the industry.  Then you tell me,  “I only need a rough estimate.” For your protection and the integrity of the business appraisal industry, I can’t give an rough guess based on a few facts.

An opinion is an opinion,  I must develop it in accordance with generally accepted appraisal standards.  These standards provide that I need to understand your both your business and the industry that you operate in reaching an opinion of value.

While I would love to be able to give quick short answers, I usually can’t.  I am not trying to be difficult.  Think of it this way, would you want your doctor to give you a clean bill of health without every doing a physical examination or running any tests?  Probably not.

©2010 Florida Business Valuation Group

The purposes of a valuation will often dictate what is included in the value. For estate and gift tax purposes, the value is of the stock or equity interest owned.  For transactions, the value may or may not include all the assets and liabilities.  In transactions, the purchase agreement usually specifies which assets and liabilities are included in the transaction.

It is important to distinguish between what is included in the value and what is included in different multiples based on market methods methods.  For example, the multiples from BIZCOMPS®, a transaction database, are assumed to be asset sales which exclude cash, accounts receivable, accounts payable and inventory.  Other operating assets such as the equipment used in the business are included in the value arrived at using BIZCOMPS® multiples.  Multiples from the Pratt’s Stats® database, on the other hand,  are for both asset and stock sales, as indicated for each transaction.  Some transactions include the working capital of businesses while others do not.  Transaction multiples from the Pratt’s Stats ® database need to be examined for the details of each transaction.

Within industries, there are often rules of thumb used by business brokers to estimate the value of business.  Different industries treat the assets differently. Beer taverns, according to the Business Reference Guide, sell for 6 times monthly sales plus inventory OR 1 to 1.5 times annual earnings before interest and taxes OR 55 percent of annual sales plus inventory.  Other types of establishments that sell alcohol have different multiples and treat the assets differently.  Rules of thumb for cocktail lounges either add inventory back, add liquor license and inventory, OR add fixtures, equipment and inventory.  As illustrated, different multiples from different sources result in values that need adjustments for different assets and/or liabilities.

So what does all this mean?  A business valuation will clearly state whether the stock or equity interest in a company or the net assets are being valued. If a business valuation has not been done, understand the value from the multiples you chose.  If necessary adjust for assets and/or liabilities which are not included.

©2010 Florida Business Valuation Group

In general, a business is usually worth at least as much as its net assets (assets less liabilities).  A profitable business is usually worth more than its net assets.

Typically, healthy businesses produce a return on both the tangible and intangible asset in the form of profits and cash flow.

When a business is operating at a loss, it may indicate that the intangible assets have little or no value.  However, losses can arise from situations other than diminished goodwill, such as the current recession.

If a company does not have prospects of operating profitably in the future, a rational owner would choose to close the business and sell the assets. At a loss, the company is not producing a return on its tangible or its intangible assets (assuming there are intangible assets.)  However, if the company is expected to rebound, the business can still have value.  In other words, loss companies can still have value.

The challenge is to determine what value a loss company has in excess of its assets.

©2010 Florida Business Valuation Group

The valuation process  is based on a body of knowledge and generally accepted appraisal practices.  The appraiser applies his or her informed judgment, based on the facts and circumstances related to the business to arrive at an opinion or conclusion of value.  The appraiser then documents the relevant information and explanations, supporting his or her conclusions in a valuation (or appraisal) report.

The business appraisal review process examines the credibility of the valuation work product, looking at the information in the report and the methodologies used.   If a report fails to disclose sufficient information, has analytical gaps or misapplies methodology, it may be found to lack credibility.

There are three types of review opinions:  a finding of concurrence, a finding of non-concurrence and a finding of no opinion.    A finding of concurrence indicates that the report is credible.  When there is insufficient information for the reviewer to issue a review opinion, a finding of no opinion will be issued.

A business appraisal review is not an opinion regarding the value of a business.  It cannot take the place of a full appraisal as a second opinion.

If you have questions regarding when a business appraisal review is needed, you can post or question or email me.

© 2010 Florida Business Valuation Group

Julia writes:

The “Hit By a Bus” Plan

No one plans to be hit by a bus, of course, but what if a sudden, unexpected event occurred in your life? Accidents do happen, as do other significant events that require a business owner to be away from the business for a lengthy period of time. If this happens to you, who will be running your business bright and early the next morning?

If the answer to that question is that the doors would close, maybe not the next day, but soon, then it is time for you to have a plan. In this tightening economy, most businesses could not afford to shut down for even a short time without losing customers and suffering devastating financial consequences.

Whether it is just you running your business or you have a team of loyal employees, someone is depending on your business to continue to operate should the unthinkable happen. What would happen to your family and the families of your employees if no one else were able to run your business in your absence?

The key to business continuation is having a detailed Operations Manual with instructions for “how things are done.” It should cover all of the different systems you have in place and descriptions of the different positions employees hold in your company. If someone can step in and have a written guide to how the business is run, even if they are unfamiliar with the day-to-day processes, then your business has a chance of surviving, and thriving.

An Operations Manual is the master plan for how your business operates, and should cover all of the “steps” you keep in your head. The content of a manual will vary from business to business because the systems that each business uses are different, but the basic structure of an Operations Manual should be consistent. Even the simplest things should be included, like passwords to access the computers and accounts.

If you have no employees, it is just as critical to have a manual so that your family, friends, or other designated individual can step in and answer clients’ questions, retrieve their projects and information, and keep the bills paid until you are able to return to the helm. In fact, having an Operations Manual can be a selling point for solo practitioners when pitching the company to clients. They may wonder who will handle their work or their concerns if you are temporarily away from the business.

An Operations Manual means the difference between a business that can run while you are out of the office, and one that cannot. It will alleviate the stress of wondering what will happen to your company if you are “hit by a bus.”

© 2010 Florida Business Valuation Group

So what does that mean? Date specific is easier to explain. A valuation is a snapshot of a particular type of value as of a specific date. Most people can understand that they would not necessarily buy or sell publicly traded stock based on a price from three months ago. They would make their decision based on today’s price. While the value of a private company may not change significantly over time, it also could change. The value is determined based on the known or knowable facts as of the valuation date. It does not take into consideration changes in the economic climate after the valuation date, or increases or decreases in revenue. Either of these factors could result in a change in value from one date to another.

Valuations are also purpose specific. Some different purposes could be gifting an interest, the value of a business for a divorce or the value for a dispute with a shareholder. Since different types of value may be used for different purposes, the resulting values may be different. For example, a gift of a 10% interest (minority and non-marketable) could not be used to estimate the value of 55% interest of the company (control and non-marketable) for purposes of a shareholder. The minority interest may have been reduced by discounts for lack of control, whereas a 55% interest would usually not have a minority discount applied. The discount for lack of marketability for a 10% interest could be different than for a 55% interest, and in some shareholder disputes, state statutes may dictate that no adjustment be applied. This example also indicates that two interests, a minority and a controlling interest could have different per share values based on other factors as well. Appraisal reports state that they are for a specific valuation date, valuating a specific identified interest and for a specific purpose. This is so that an uniformed user would not mistakenly misuse the valuation report and reach an inappropriate conclusion.

© 2010 Florida Business Valuation Group

The advantage to a business valuation is it provides the user with the value of a business or interest in that business.  The advantage to a business valuation is also the major limitation.  The business appraiser will usually provide a single value, based either on fair market value or investment value.  (See blog post here)

Value is a range, though, and there are many different types of value within that range.  As a buyer, you are only concerned with the lowest value within that range that you can pay.  If you can negotiate a lower price than fair market value, you will.

Valuations can be expensive.  If one is not necessary for you to negotiate a deal, you should not pay for one.

The seller has established a starting price for your negotiation.  What you need to determine is whether the cash flow from the business can support that price.

Each buyer has different criteria for whether a deal will work for him or her and there is no right answer.  The things that buyers should consider include:

• What is your risk tolerance?
• What is your required rate of return?
• How long are you willing to wait to get your investment back?
• Will cash flow from the business be sufficient to pay off any debt used to buy the business?
• Will cash flow from the business be sufficient to pay your salary if you are working in the business?

These questions will provide you will the information to determine if the asking price meets your criteria as a buyer.  A business may be worth $100,000, but a particular buyer may not be able to afford the asking price.

Price is the negotiated amount for a particular transaction.  While you need information to make an informed decision, a valuation will not necessarily give you that information.  Your financial professional should be able to assist you in determining whether the asking price of a business meets your criteria.

© 2009 Florida Business Valuation Group

So what does a balance sheet tell you about a business? A balance sheet typically has the historical net cost of the assets a business has acquired over time. The balance sheet does not tell you the type of assets, their age or condition. Older assets may be depreciated and have a very low book value, but still be fully functional in the business. The balance sheet does not indicate what future capital expenses will be to either replace old equipment or to support future growth. Intangible assets, including intellectual property and goodwill, are usually not reflected on the balance sheet even though they may have substantial value.

A balance sheet reports the liabilities of a company. Unless you are reading footnotes to the financial statement (assuming the financial statements have footnotes), the balance sheet usually does not tell you the terms of the liabilities or when they mature. It also does not reflect how old the payables are or whether the company has unused lines of credit. Understanding the obligations of a company is necessary in understanding its value.

Is value better reflected on the income statement of a company? Many people think that profitability, which is reflected on the income statement, the primary element contributing to value. There are two potential problems with this assumption. First profitability is not the same as cash flow. For example, necessary investments in capital expenses for new equipment can impact cash flow while having a minimal impact on profitability. The other issue is the assumption that the level of profitability reported will be sustainable. A business can have increasing sales over a prior year, but if its receivables are increasing at a faster pace, there could either be a problem with collections or the growth may not be sustainable.

Financial statements provide important, but limited information about a company.  Understanding the financial statements is only the beginning in the process of determining the value of a company.

©2009 Florida Business Valuation Group

There are some major distinctions between the underlying data used for each method.  The public guideline company method uses information from publicly traded companies that are most similar to the company being valued.  The appraiser’s analysis of comparability may include factors such as type of business, size, geographic operations, growth prospects, past historical operating performance and any other factors which may be appropriate.  The appraiser identifies the most comparable companies and then derives valuation multiples based on the trading prices of the guideline companies’ stock as of the valuation date.  This data is based on marketable, minority interests in the guideline companies.

Private company transaction methodology is generally based on the theory that a sufficient number of private transactions will emulate the market for that type of company.  There are a number of databases which track private transactions of companies.  The information is collected from business brokers and intermediaries involved in the transactions, who report the information to the database services.  Each database contains different amounts of information regarding the companies.  The information about these companies represents a non-marketable, control interest in the transaction companies.

So what is the difference?  The public company transactions are evidence of the market value based on a large number of transactions which have been completed between buyers and sellers.  That is the reason that a large number of public companies is not required in order to use the methodology to arrive at valuation multiples.  Each company alone is evidence of the market.

Private company transactions may or may not take place at market value. Buyers and sellers have their own motivations for entering into transactions.   There is only one transaction for each company, unlike with public companies where you could have anywhere from under one million to over 250 million trades in a single day.  The concept behind private company transaction methodology is that with a sufficient number of transactions, the average or mid-point will represent what the market looks like.  That is why more transactions are necessary under the private company transaction methodology.  A few transactions may not be sufficient to represent the market.

What is important to understand is that each valuation is different. Applying any methodology is based on the facts and circumstances particular to the company being valued and the valuation date.

©2009 Florida Business Valuation Group