The Art of Business Valuation

Accurately Valuing a Small Business

Gregory R. Caruso

• Publisher: Wiley
• Year: 2020
• ISBN:
  9781119606017
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Valoración

Starting from the practical viewpoint of, "I would rather be approximately right than perfectly wrong" this book provides a commonsense comprehensive framework for small business valuation that offers solutions to common problems faced by valuators and consultants both in performing valuations and providing ancillary advisory services to business owners, sellers, and buyers. If you conduct small business valuations, you may be seeking guidance on topics and problems specific to your work. Focus on What Matters: A Different Way of Valuing a Small Business fills a previous void in valuation resources. It provides a practical and comprehensive framework for small and very small business valuation (Companies under $10 million of revenues and often under $5 million of revenues), with a specialized focus on the topics and problems that confront valuators of these businesses.

Larger businesses typically have at least Reviewed Accrual Accounting statements as a valuation starting point. However, smaller businesses rarely have properly reviewed and updated financials. Focus on What Matters looks at the issue of less reliable data, which affects every part of the business valuation. You'll find valuation solutions for facing this challenge.

As a small business valuator, you can get direction on working with financial statements of lower quality. You can also consider answers to key questions as you explore how to value each small business.

• Is this a small business or a job?
• How much research and documentation do you need to comply with standards?
• How can you use cash basis statements when businesses have large receivables and poor cutoffs?
• Should you use the market method or income method of valuation?
• Techniques that improve reliability of the market method multiplier
• How might you tax affect using the income method with the advent of the Estate of Jones and Section 199A?
• Do you have to provide an opinion of value or will a calculation work?
• How do you calculate personal goodwill?
• As a valuation professional how can you bring value to owners and buyers preparing to enter into a business sale transaction?
• How does the SBA loan process work and why is it essential to current small business values?
• What is the business brokerage or sale process and how does it work?
• How do owners increase business value prior to a business sale?

This book examines these and other questions you may encounter in your valuation process. You'll also find helpful solutions to common issues that arise when a small business is valued.

CHAPTER 1
What Is My Business Worth?

In theory, the value of a business or an interest in a business depends on the future benefits that will accrue to it …

—Shannon Pratt, Valuing a Business, 4th Edition (New York: McGraw-Hill, 2000)

What is my business worth? This is the essential starting point for business valuation.

VALUE IS NOT PRICE

Price is what someone is willing to pay for the business. Price includes the quality of the sales process, negotiation, emotion, economic demand, timing, luck, and financing. Price for private businesses often includes terms with post-closing price adjustments based on continued business performance or adjustments due to failures of representations and warranties. These terms are hard to translate into useful data. There are no mechanisms to determine downstream what actually gets paid for earn-outs and seller notes.¹ There is no verifiable data on how often representations and warranties result in post-closing price adjustments. The importance of emotion in the sales process cannot be overstated. It takes tremendous energy to buy or sell a business. This is diametrically opposed to the valuation process.

VALUE IS …

Valuation consists of applying established analytical methods and preset assumptions to what is known or knowable about a company in order to estimate its value as of a specific date. These assumptions rarely resemble real-world sales situations. Value and valuations are useful for sale and exit planning discussions but they do not represent prices. In the same way, value is useful when there will not be an arm's length sale. Value is the best that can be done for situations such as adding or removing owners, divorce, litigation, and required compliance situations, for example bank loans, estate and gift taxes, Employee Stock Ownership Plans (ESOPS), fairness opinions, and the like.

Value and price are related but not the same. The only way to determine its price is to buy or sell a business.

Most of this book is about how to value a business. Chapter 13 addresses working with business owners to prepare them and the business with an exit strategy. The chapter concludes by explaining ways to sell small businesses in the market for a price profitably.

NOTE

1. 1.  Earn-outs are adjustments to the price based on results that occur after a sale closing. Seller notes are sometimes adjusted or not paid after closing. Each of these can be viewed as an adjustment to the price paid. There is no mechanism for these post-closing price adjustments to be reported to the transaction databases.

CHAPTER 2
Valuation Basics

This chapter covers the basic business valuation assumptions and methodologies that are the necessary building blocks of every estimate of value.

VALUATION IS MODELING

Business valuation is the process of taking a subject company and, through the application of different models, estimating a value. Different models work best in different situations. Each model is generally referred to as a method in business valuation. Selecting the correct model is done using professional judgment, reviewing all available information along with the standards of value and purpose of the valuation.

A key concept is that business valuation models tend to be comparisons. In each case, there are two sides to the comparison: the subject company and the comparables. It is important to try to align the two sides as closely as possible. When that is not possible, it may make sense to use another model. Sometimes there is no model that is close and more professional judgment than is typical will be required.

There is no perfect method, only useful methods. However, even a useful method can be applied in a misleading way. At every level, selection of the model and then proceeding to choose and screen the inputs for comparison, are key to a supportable valuation.

All comparisons have shortfalls. There is no perfect data on either side of the modeling equation. Our job as valuators is to impartially align the two sides and then account for variances where possible, using the method to project into the future.

What is important is considering what will improve our model. Ask the right questions, use the right model, select inputs for apples to apples comparables and then adjust as reasonable. Finally, ask, “Does this make sense?” Work with the case until the answer is YES. That is the truest application of “I would rather be approximately right than perfectly wrong” and that is the Art of Business Valuation.

THREE PRIMARY APPROACHES TO BUSINESS VALUATION

There are many models or methods for valuing a business. These fall into three main approaches.¹ It is important to select the best model or method in order to obtain the most accurate business valuation.

There are three primary approaches, each with different methods for valuing a business. The approaches are the market approach, the income approach, and the asset approach:

1. Market Approach. The market approach uses the theory of substitution. Market comparable sales are substituted for the company being valued. In practice, this means that market comparable cash flows and financial information are compared and substituted for the subject company to estimate a value. This is the primary means used for valuations of small and very small businesses.
2. Income Approach. The income approach examines what an investor would pay for a business, based primarily on its cash flows. Investors have many choices of how to deploy their money. Using financial data collected since 1926, the risk and reward actions of investors are used to estimate the value of the subject company.
3. Asset Approach. The asset approach estimates the current value of the individual assets of the business. These approaches tend to ignore or underestimate the value of intangible assets, such as goodwill. For this reason, the asset method is often referred to as a floor value. If the business is not generating value based on its cash flows in the market approaches and income approaches, then the assets may be sold, establishing a floor value or high liquidation value. The asset method tends to be used when the subject company may be considering whether to stop operating, owns valuable assets such as real estate, definable and protectable intellectual propert...