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.

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.

5 Ways To Raise Extra Money When Buying A Small Business It's common for someone buying a business to discover he or she will need more cash than expected to take over the company. In addition to the down payment, money will be required for working capital. Here are five of the most popular strategies buyers have employed to get the extra funding needed. A surprise that some entrepreneurs encounter when buying a small business is that the amount of money expected to go into the purchase will not cover every expense involved in becoming the new owner. Not only is it necessary to come up with the down payment, but in order for the business to succeed the buyer will need working capital when taking over. Smart strategies for raising that extra money include: 1. Seller Financing: If the deal calls for an all cash purchase, and the buyer is emptying his bank account to p ay off the seller, perhaps the agreement can be modified to include a promissory note to be used by the buyer for part of the price being paid. That will free up some of the cash originally intended for the down payment. The seller may find tax benefits to this arrangement. Besides, making sure the buyer has sufficient working capital is an important way to help her succeed. 2. Inventory On Consignment: The buyer can save the money that would ordinarily go for purchase of the inventory at close of escrow, by paying the seller the wholesale costs for inventory items only as they are sold to customers of the business. Rather than the buyer's several hundreds or thousands of dollars tied up with parts or products, it can be used for other expenses and the seller will be paid for each item of inventory as the buyer sells it. 3. Earn-Out Agreement: Another way for buyer and seller to work together to make sure th e business won't run into trouble for lack of working funds, is their agreement to establish a lower selling price than was originally planned. That can call for a lower down payment than the amount stated in the sales agreement. The seller will be compensated later, under the earn-out provision of the sales contract. It would specify that the price is linked, by an agreed-on formula, to a specific low performance level for the business. As the business outperforms this initial projection, the price would rise according to that formula. That means the seller sacrifices at first, with lower payments for the balance of the price than he wanted. But as the price of the business goes up, so will the amount owed to the seller, as expressed in larger payments. 4. Borrow From Financial Institution: The buyer may be able to get extra money from a bank or other financial institution. If there is seller financing involved in the deal, another lender i s more likely to agree to approve an application for a loan to help fund working capital. And it's a good idea for the buyer to start shopping among financial institutions before he or she finds a business to buy. That way the buyer will know which company is likely to offer the needed cash. 5. Assume Seller's Debt: If the seller will need cash at close of escrow to pay off business creditors and deliver the business free and clear of debt, the buyer may be able to assume that debt instead. That will require the cooperation of the vendors to the business. Some or all are likely to go along with the plan as it will insure their continued relationship with the business. A shortage of cash to take over a business need not stop a buyer from proceeding if he or she can use one or more of these methods to raise additional funds before taking over the business. About The Author: Peter Siegel, MBA is the Founder & President of BizBen.com (businesses for sale, businesses wanted to buy, resources, & articles) and the BizBenNetwork Online Community. He advises and consults with business buyers, business sellers/owners, brokers, agents, investors, & advisors on a daily basis. Reach him direct at 866-270-6278 to discuss strategies regarding buying, selling, (or financing a puchase of) small to mid-sized businesses.

Buainess Appraisal Reports Clarified

Most people would think that the business appraisal sector would be a very organized group, but they are not. I recently reviewed an article on a business appraisal technique by a writer from a Business Appraisal Association and half the professional appraisers responding did not agree with the writer.

First off, there is not a single standard method of appraising a business and none of the individual methods used by its self provides an accurate appraisal. There is also a vast divergence of quality business appraisers and business appraisal reports. I classify them into six different groups.

1.      The dedicated professional appraisers who mainly do large private corporations and charge large fees to do these complicated assignments. They understand the complexity of business appraisals and provide quality work.

2.      The typical small business appraisers may use four or five different methods in the same report and give each method a percentage weight. How they come up with the different weights I’m not sure. It seems as if they have already decided on the appraised value and adjust the weight percentages to justify their final appraisal number.

3.      The smoke and mirrors group will fill the appraisal with all kinds of useless reports and complex terminology. I have seen reports that are so grammatically and mathematically complex that they are totally impossible to understand. The writers rely on impressing their clients with their brilliance, hoping the reader can’t understand the report enough to realize they wasted their money. These appraisals tend to be extremely inaccurate.

4.      There are the on line groups charging very little for an appraisal. They can’t afford and probably don’t spend much time analyzing the business, its Financial Statements, Tax Returns and other important documents. The sample appraisals I have seen were inaccurate. I spend much more time analyzing the business and its financial documents than I do writing the report. A business appraisal is not an on line fill in the blanks type of report. It takes a knowable experienced expert who will take the time to truly analysis the business.

5.      Those that use the capitalization rate and rule of thumb methods are providing their clients with the average value of all the business used to determine the capitalization rate or rule of thumb numbers. Each business is different and an appraisal has to address the specific parameters of the business being appraised to be accurate.

6.      The blended method uses a combined report using the cash flow, asset and market value approaches to determine the business value. This blended method looks at all the elements that create value in a business and provides an appraisal unique and accurate for each business appraised. This method consistently works. Check out my blog for more information on this method. http://appraisalsbusiness.blogspot.com/

Most of the inaccurate appraisals I have seen appraised the businesses with a much higher value than they were actually worth. Some of the values were three times higher than the actual value. It also seems like the larger and more complex the reports, the less accurate they were. Quantity over Quality.