A Guide to Business Appraisals


There are a number of standard appraisal methods used to value a business that include, Asset approach, Income approach, Market approach (Comps), Capitalization of Earnings and Discounted Future Earnings. Each one of these methods individually does not always represent the true value of a business. We have seen appraisals where the derived value of these five different approaches varied by 500%.

Also used are Rule of Thumb values based on multiples of adjusted profits or percentages of gross sales. The rule of thumb methods only work when there are many similar businesses having the same operating expenses and assets. This doesn’t always happen and when you use the method on more unique businesses it just doesn’t work.

Using Comps tends to give the average value of the compared businesses and not the value of the business being appraised.

Capitalization of Earnings and Discounted Future Earnings are less often used and tend to end up with values that also tend to give the average value of the type of business.

After working with the standard methods for some time and evaluating what creates value in a business we learned that combining the Asset, Income and adding market influences into a single method gave an accurate market value. Having been involved with our own Business Brokerage for over twenty years we were also able to look at the businesses we sold and adjust and refine the combined method to reflect a True Market Value Appraisal.

The next step was to find a way to keep the through detailed analysis of the business being appraised and present it in a simplified easy to read manner. By looking at the components of a business that created value and categorizing them into Income, Assets and Market related we were able to create an Excel program to present the appraisal. The program was designed to be flexible so that it can be changed to meet different types of businesses and the many different purposes for business appraisals. This system may look simple but the complexities of doing an appraisal are still applied. There are many things that we still consider that are not listed in every report. When they are needed we add them into the Excel program.


Appraisal Requirements

For an appraisal system to work it must address the following:
1. the profitability of the business
2. the tangible assets of the business
3. the presence of intangible assets
4. the value derived should represent the market value
5. have flexibility to allow for the terms of a sale.
6. simplicity - Usable and understandable.

The first step was to determine what components in a business have value. These are some of them:
1. a functioning business with modest growth
2. skilled employees
3. working equipment
4. adequate usable inventory
5. a quality product or service
6. a profit
7. collectable receivables
8. a broad customer base with no very large customer
9. some new product development capabilities
10. a good reputation (name) in the market place
11. a clean, adequately sized work area
12. a financially sound operation with a good accounting system
13. the business located correctly for its market place
14. a good base of suppliers

After building this list it has to be divided to fall into a profit/asset based appraisal system. They are categorized as follows:
1. Profit based items.
a. business profit
b. a functioning business
c. business size - gross sales
d. intangible assets
1. skilled employees
2. a quality product or service
3. a broad customer base - customer list
4. new product development capabilities
5. a good reputation - business name
6. good financial management

2. Asset based items:
a. inventory
b. equipment
c. receivables
d. contracts
e. patents
f. trademarks
g. real estate

By Robert A. Klein, President and owner of Business Appraisals, providing business appraisals on all types of businesses. Former President and owner of Business Search, Irvine, California, a Merger & Acquisition firm specializing in the sale of manufacturing, distribution and related businesses, with programs for both buyers and sellers.

Market Value Business Appraisals www.businessappraisals.com

Market Value Business Appraisals www.businessappraisals.com

Clear
Our business appraisals are written to be easily understood. We use common business terms, comprehensive step-by-step mathematical analysis and a thorough explanation of each step in the process. The result is an easy to read and understand report.

Accurate
By researching and analyzing business sales to determine components that represent value, we have created an accurate appraisal process. It is realistic and represents true market value. No rule of thumb or comps, our appraisals are unique to each individual business.

Affordable
By standardizing and simplifying the appraisal process we can offer more affordable pricing for our services.

Business Appraisals
800-829-4842
949-254-4062 Cel
www.businessappraisals.com/rklein@businessappraisals.com

Blended Is Better!

There are a number of traditional accounting methods used to calculate business worth. None of these methods individually addresses all of the items that create value. One method looks at assets/liabilities while another will look at cash flow or market comps, each separately. It is not uncommon to see five different methods used for an appraisal, each being weighted or one being picked as the proper method with out any logical or statistical justification.

During my 23 years as a Business Broker and president of Business Appraisals I found that blending three of these different methods into one appraisal method captures all elements of a business that have value.

First I look at the P&L statement and cash flow. Adjustments are made in the form of add backs which, depending on the purpose of the appraisal reflect the cash flow of the business before discretionary spending of the owner/owners. A multiple that is statistically based on 25 years of business sales and appraisals is used to determine the cash flow value of the business.

Second I look at the Balance Sheet and the net worth (asset/liabilities). Again, adjustments are made based on the purpose of the appraisal. Book value is adjusted to reflect market value for equipment and real estate.

The third part of this appraisal process look at market conditions that reflect value, such as sales growth or decline, customer percentage of gross sales, profit margins and other market influenced items as needed.

All of this is then presented in a concise logical form with a description for each step in the process, giving the user a clear, understandable, accurate and affordable business appraisal.

Discount for lack of marketability and control

Over the years I have been asked to calculate discounts for lack of marketability and control for minority business shareholder buy backs. It bothers me that business owners in need of operating capital for their business will sell minority interests, but when it becomes time to buy out these minority interest they expect the value to be discounted (these discount can be as much as 40%). They are happy to take the investment money and at times not even pay any yearly dividends but reluctant to pay back the full value of the minority shares. I can see that if a minority shareholder tries to sell his shares on the open market these discounts may apply, but it also seems to me to be unreasonable for a stock buy back to go this route. If you or any of your clients are considering a minority investment in a business make sure the sale contract contains language that prevents the business from discounting minority share values upon buy back. If you are going through a buy back, get an appraisal on the business. Business owners tend to offer lower values on stock buy backs than the stocks are actually worth. My experience is that businesses buying back their minority shares tend to offer 50% or less for these shares before consideration of any minority discount.

Creating an Accurate Business Appraisal

Appraising businesses accurately is not an easy task. There are many different methods that can be used along with variations for the purpose of the appraisal. None of these methods, by its self addresses the total value of a business. One method might look at cash flow value, another at asset value and another at a capitalization rate. It is up to the appraiser to pick what he thinks is the appropriate method. Some appraisals may use five different approaches and gives each of the approaches used a percentage of the final value with no justification as to why one may be 75% and another 5%. Purpose also changes, as an appraisal done for the sale of a business will be different than one done for a divorce or an IRS requirement. One of the methods often used for divorce purposes is the “Excess Earnings Method” which was developed in 1920 to estimate lost goodwill suffered by breweries and distilleries because of Prohibition. It was never intended to be used to appraise businesses. I believe it is used because the math involved is very confusing and the method can be easily manipulated to provide a wide range of business values. There is great variance in the quality of business appraisals. It is easy to pick up an accounting book and find the different methods of doing an appraisal, picking out a formula and plugging in some numbers. This process doesn’t give you an accurate appraisal. Most accountants know this and turn to an experienced Business Appraiser for an appraisal. Also, be aware that there are appraisers that stuff the appraisal with irrelevant and highly technical information to exaggerate the complexity of the appraisal to charge a higher fee for their services. Some over inflate the appraisal to make an owner feel he has a high value business. During my 23 years of running my own Business Brokerage business I used the data from the business sales we made to develop a method that gave me the accuracy I wanted. I came up with a blended method of appraisal consisting of cash flow, asset value and market analysis. This blended method evaluates all items that create value in a business. I never have to guess if I am using the correct method or find percentages to use for each component. I have successfully used this process for over 25 years for business sales and business appraisals. My goal has always been to provide clear, accurate and affordable appraisals that meet the needs of my clients.

Rule of Thumbs

Rule of thumbs are general averages of similar types of businesses. If all businesses were equal then the rule of thumb method would work, but no two businesses are alike. The problem to a buyer is that there are excellent and terrible businesses in this group of similar businesses. The only way to make sure you are buying one of the excellent businesses is to have all the financial records evaluated by an expert. It may cost to do this, but it could be the difference between success and failure.

Unbiased Business Appraisals

Recently, I was involved in a divorce trial testifying on behalf of the wife who had an interest in the business her husband ran. Besides my business appraisal there was another business appraisal presented by the husband’s appraiser. The method he used is called “The Excess Earnings Method” and was developed by the US Treasury Department in 1920 to estimate lost goodwill suffered by breweries and distilleries because of Prohibition. It was never intended to be used to appraise businesses. The problem with this method is that it is hard to understand and therefore very easily manipulated. . The sales of the business were $635,000, with cash flow of $266,000 and assets of $186,000 (including $146,000 cash). The husband’s appraiser came in at $196,000. My appraised value was $560,000. My appraisal worked out to be less than two times the cash flow plus the assets and was an accurate valuation. Don’t take for granted that every appraiser will produce an unbiased appraisal, especially those using the Excess Earnings Method.