Posted By johnhalstvedt - 05/23/12
Valuation is often misunderstood. Most people have experienced an appraisal when buying a home. Banks require an appraisal by a certified valuation expert who has no financial ties to the transaction to ensure the property has sufficient value to justify the loan. For very good reasons, the bank will not accept the seller's opinion of value or the selling broker's opinion of value. We feel strongly that a business buyer should understand the components and the methodology behind a business appraisal to ensure that they make a wise decision about their future. Relying on hearsay or broad "rules of thumb" for an industry can be very misleading and can lead to missed opportunities and misleading deals.
When you should know the value
In a perfect world, a business buyer would have the ability to determine a general range of business values in an industry or location before they begin a business for sale search; just as a home buyer has rough idea of prices per square foot in a given neighborhood. But assessing business values is not nearly as simple. Let's use an example: you love bicycling, camping and Colorado. Well, okay, who doesn't? You would like to own either a bike shop or a campground somewhere in Colorado. Bike shops and campgrounds have very different values, because campgrounds include real estate and bike shops are usually in leased locations. Colorado has locations that have two seasons for some types of business but usually not for bikes and camping (unless the bike shop also sells skis!). You only have so much money available for your dream, and you need to know if you can afford a particular type of business in the location you love. Don't waste your time on something that will never happen.
How to begin
For many businesses, valuation information is available but difficult to weigh and interpret without direct experience. If you can't swim, you buy and read a book on swimming and then jump off the dock, right?! A better and safer approach might be to have an instructor walk you into the shallow end and show you how it is done first. A qualified and experienced business advisor should be able to help you determine a reasonable range of values for your favorite industries and locations based on reliable data from actual sales.
Big business vs small business
We like to say, "you can't play baseball with football rules". It is the same with business. Lots if information is published about values and sales of public companies. Absolutely none of it applies to small business. Public companies want large profits to attract people to buy their stock. Small businesses try to minimize profits to avoid paying taxes. Larger businesses have layers of management and small business owners wear many hats. Information on the web could be accurate, but much of it is wrong or misleading and little is specific to your circumstances. If you learn about how and why valuation methods are used, you will be better at recognizing a good deal when you see it.
The distinction between value and price.
Value is the amount at which a business might change hands between a willing seller and buyer when the seller is not under any compulsion to sell and the buyer is not under any compulsion to buy, both parties having knowledge of relevant facts. In the real world, however, compulsion works both ways: Sellers try to create buyer competition, and buyers look for owners who must sell. Accordingly, price may be greater or less than value.
Seller financing affects price.
Acquisitions, which were financed by the seller, sold for a 15% (median) higher price than all-cash transactions. The average down payment was 37%. Toby Tatum, Transaction Patterns
"This difference is more pronounced if we compare the all-cash transaction to those selling with seller financing of 70% or more. In these deals, the median sale price was 27% higher than all-cash transactions. What the data reflects is that if a seller is willing to accept a down payment of 30% or less, the full price will increase 25% or more." Tom West, Business Brokerage Press
Goodwill vs. good luck.
The IRS defines goodwill as the difference between the selling price of a business enterprise and the value of its "tangible" assets.
A buyer may pay for goodwill if a seller can demonstrate, because of the business' unique competitive advantage, that it has the ability to generate a profit above a reasonable return on the business' assets.
Practicality drives price.
Competent appraisers and wise business buyers believe the appropriate price (and terms of purchase) for a business:
- Enable the business to survive the terms of the purchase financing.
- Employ reliable methods of valuation specified by the IRS in Revenue Ruling 59-60, among others.
- Structure the terms of purchase to minimize tax.
There can be a difference between fair market value and acquisition price, and the price itself can vary. What is reasonable for one buyer might not be for another buyer.
A special thanks to Ted J. Leverette, the "The Original Business Buyer Advocate®" for his valuable insight and assistance with these articles.