Thank you for having me. The attached slides are available in conjunction with our SBA 7(a) Loan – SBA Business Valuation Presentation. Note, the SBA often refers to business valuations as SBA business appraisals.
In our SBA Business Valuation / SBA Business Appraisal Presentation we cover the following three topics.
Very high level business valuation theory. Namely why we cannot just average the last three years financials and select a multiplier or other risk adjustment factor and come up with a value.
SBA Business Valuation particulars. What you need to know and do to get a business valuation quickly and easily.
Covid-19 aftereffects (we hope) and how we work with financial “holes” and “bubbles” etc. so you and your client can be prepared.
Have you ever asked yourself: how will I ever clean up this financial statement mess for a business valuation? You are not alone. Many small companies have notoriously improper financial records and error filled financial statements. This is often caused by a lack of understanding of what is required to have proper financial records. It is also caused by the drive to keep overhead as low as possible, which is an admirable goal that sometimes goes too far. If the company is profitable, the owner and management may get away with sloppy records until they need to apply for a bank loan, add a partner, or perhaps sell the business; or they need a business valuation for another reason.
One of the primary differences between valuing micro and small businesses and larger businesses is the quality of financial statements. Larger businesses tend to have reviewed financial statements at the very least, while many have audited statements. These businesses have true accounting and financial departments and people with the skills to keep proper GAAP records– or at least to understand and report the variances.
One of the nice things about running a small business is you get to run it your way. But, when third parties need to review your financial statements, you need to do it their way, at least to a certain degree. Here are some ways to get these financial records in shape for someone else to use them.
Know the limits of cash basis accounting.
Cash basis accounting is one of the most common things we see with small businesses. This is an accepted method of accounting, but it might not give useful financial information for many purposes. Cash basis is particularly prevalent on tax returns used to value small businesses since the cash basis better aligns tax liability with the receipt of money to pay the taxes.
For example, if the company being evaluated has large accounts receivables but the timing of collection varies, it can be difficult to get a complete picture of the true underlying cash flows. This is because accounting periods have end dates, but ongoing businesses do not have end dates. Each of these accounting period end dates represents a cut-off, but we don’t know what happens the next day. An income statement that ends on December 31 will not show a huge receivable collected on January 5, and therefore is not a complete picture.
Be aware of outright accounting errors.
Outright errors on company financial statements present another issue for business valuation of a small company. The valuator or other reviewer must always be on the outlook for material errors. Usually these errors are accidental, but may not always be. Errors often even show through on tax returns prepared by third party tax preparers. Some common errors are:
Overstating the cost of goods sold and understating inventory. This practice reduces profit and therefore taxes. Often companies only overstate a small amount of goods sold each year, but over time this can become a big problem. Take a small retailer with $300,000 of inventory and $90,000 of profit each year for example. If they overstate the cost of goods sold by $30,000 for 10 years on their tax return, by the tenth year, they will not have any inventory for tax purposes. However, they would still have $300,000 of inventory on the floor and in the back room. They will have also understated profits by $30,000 per year, or 25% per year–a significant percentage. Over the 10 years, they will reduce profits by $300,000. This can create both valuation and tax problems if discovered.
Failure to show inventory at all. This just creates a complete mess for inventory rich small businesses. In many cases, it leaves the company unable to be valued, obtain a loan, or be sold.
Failure to write off un-collectable accounts receivable under the accrual method. Some businesses never write off uncollectable accounts receivable. This causes income to be overstated. This is usually fairly easy to adjust if underlying data about accounts receivable is properly tracked.
Expenses being recorded under a variety of names. We have seen office rent shown as rent expense, mortgage payments, and lease expense all in the same year for the same company. Those types of errors make it hard to review the data for consistency and figure out what the real amount is if an account needs adjustments.
These are just a small sample of accounting errors that impact financial statements and tax returns used in business valuation of small businesses. As the old computer programming adage goes, “Garbage in – garbage out.” In most cases, with care we can clean these mistakes up and feel comfortable that the financial statements reasonably represent the company that is the subject of the business valuation. But in some cases, we may have pure garbage that may make giving an opinion of value in a business valuation impossible.
I’m a JD, CPA and Certified Valuation Analyst, and I know that business valuation is both an art and science. To find out more about professional valuation services for your business, contact me to learn more.
In addition to regular SBA 7a loans and SBA funding, businesses have been able to ask for additional funding through programs like the Paycheck Protection Program (PPP), the Restaurant Revitalization Fund, and Shuttered Venues Grant. Applications for the PPP closed on May 31 and slow rollouts of the SVG, The Wall Street Journal recently asked, “What is it small businesses actually want from the SBA?” And spoke to advocates, business owners, and the SBA about what the post-pandemic assistance will look like.
Below are the major points answering what entrepreneurs want from the SBA, or you can read The Wall Street Journal’s full article here.
Protect and Rebuild Businesses
Scott Gerber, CEO of the Community Company, told the WSJ, “Strategies might include expanding the agency’s outreach efforts to smaller, newer businesses, as well as giving more support to businesses in minority, rural and disenfranchised communities.” In response, the SBA says they are “designing pandemic-relief programs focused on businesses that are most in need.”
Provide Access to Capital
Traditional SBA loans look at credit scores, and if businesses failed to pay rent or other loans during the pandemic because they didn’t have the revenue, their credit scores have been negatively impacted and they might not be able to get loans. Small business advocates say that the SBA should relax rules for the loans, make sure the information on how to get loans is clear, and help businesses understand what they are eligible for.
Be More Inclusive
We all heard the stories at the beginning of the pandemic about who was and wasn’t getting PPP loans. Similarly, advocates are now pointing out that the SBA should “connect with small businesses that have historically been left behind.”
There are three business valuation approaches or methods:
The Asset Approaches are where the individual assets of the business are valued as if they were being sold.
The Market Approaches are where comparable market sales are used to estimate a value of the company.
The Income Approaches are where the risk to investors is compared to all investor investment choices to determine value.
More detail below:
The Asset Approaches are where the individual assets of the business are valued as if they were being sold. This is usually used for non-performing businesses that may be liquidated.
The Market Approaches are where comparable market sales are used to estimate a value of the company. The formula is the cash flow times the multiplier equals the value (or $100,000 cash flow x 2.2 multiplier = $220,000 value). The multiplier is developed by looking at the sales price of the comparable sales data usually obtained from reporting services and dividing it by the cash flow. (Multiplier = Price / Cash Flow or $100,000 price / $50,000 cash flow = a multiplier of 2.) For very small businesses these comparable businesses may be mainly owner operated businesses.
When reviewing the various market methods a major concern is the comparability of the selected comparable companies to the company being valued. Are they similar or very different? In addition the valuator needs to make reasonable adjustments for overall risk of the company being valued vs. the comparable set. For instance a company with two clients each at 50% is much more financially risky all things being equal than a company with 100 1% revenue clients. The multiplier should be adjusted to reflect company risk vs. the likely risk in the comparable set.
The Income Approaches are where the risk to investors is compared to all investor investment choices to determine value. Public market data is used to develop a discount rate. The discount rate is divided (along with present value adjustments) into a projected cash flow in the discounted cash flow income method. This is a quite complex formula. A more commonly used income method with small businesses is the capitalization of earnings method. In this method a capitalization rate which is a discount rate minus a growth rate is applied to historic earnings adjusted by the growth rate for the next year (selected historic cash flow of $100,000 and a 3% growth rate = $103,000 adjusted cash flow / .25 (a discount rate of .28 – .03 growth) = $412,000 value). Discount rates are generally developed for very small businesses using the build-up method (also called the BUM). In short, the cost of capital for different layers of business risk has been calculated looking primarily to public companies and public information.
Each layer of a build-up should be carefully reviewed to make sure it was developed correctly as of the proper valuation date. The last layer in the buildup method is specific company risk which is valuator judgement where all of the specific strengths and weaknesses of the business are accounted for that may impact Risk. Note that Risk for business valuators is the perceived likelihood that future cash flows will not be met.
In all cases there is tremendous judgment in estimating a multiplier, discount or capitalization rate. Which method to use depends on the facts in the case and the available data. For smaller and micro businesses (I define as usually under $10 M revenues) there often is quite a large amount of market data which should favor using that method. For businesses over $10 M in revenues there may not be enough relevant data to use the market method. Then the income method is likely to be the best method. Remember, methods are models and none are perfect. We must select the best method based on all factors. That, is professional judgment at work.
In all cases, use common sense. Make sure the selected value ties into the risk (and has some relationship to a price someone would pay) of the company including likely economic, industry, and other foreseeable changes in the future.
Greg Caruso, JD, CPA, CVA, the author of “The Art of Business Valuation, Accurately Valuing a Small Business” 2020 published by Wiley is always available to prepare (or review) business valuations for all purposes and situations.
