THE ART OF BUSINESS VALUATION
Accurately Valuing a Small Business
Gregory R. Caruso
© 2020 by John Wiley & Sons, Inc. All rights reserved.
ISBN 978-1-119-60599-7 (hardback)
ISBN 978-1-119-60600-0 (ePDF)
ISBN 978-1-119-60601-7 (epub)
This book is a teaching tool, desk reference, and guide to valuing small and very small business. The focus is on businesses with under ten million dollars in revenues. Namely most businesses.
“I would rather be approximately right than perfectly wrong.” is an appropriate premise for valuing small and very small businesses. Business valuation is an Art not just accounting and finance. This book is valuable for valuation analyst, CPA, business owner, business broker, and attorney working with small business valuations and exit planning.
What Is My Business Worth?
Difference between Price and Value.
Valuation is modeling using professional judgment and analysis. Topics covered are valuation approaches, asset approach, market approach, income approach. Calculations of value and Conclusions of value. Standards of value, fair market value, market value, investment value, synergistic value, fair value, intrinsic value, liquidation value; Valuation purpose, premise of value. An analytical framework of a business valuation, mechanics of preparing a valuation, professional judgment.
Why Are Small and Very Small Businesses Different from Larger Businesses?
Valuators face problems with small company data for both the subject company and the comparable data. Small businesses tend to have risky concentrations and a lack of projections. For very small businesses it is also critical to determine if the business is an actual business or a job.
Assessing the Subject Company
An overview of documentation for a business valuation including document request, management interviews, sources of third party data. Detailed topics include all forms of financial and business information, add-back documents, management questionnaires and interviews including systems, people, processes, facilities and equipment, technology. Review of concentrations. How to rank strengths and weaknesses. Deal killers such as state taxes, lawsuits, real estate lease issues, licensing, government regulation and status certifications, internal disputes, downward trends, poor balance sheet and lack of employee agreements. External factors and sources of data about the economy and industry information. Financial analysis including, common size statements, ratio analysis and sources of comparative financial data.
Normalization of Cash Flows
The process of normalizing or estimating an apples to apples cash flow. Primary cash flows reviewed are revenues, earnings before interest, taxes, depreciation, amortization, (EBITDA), sellers discretionary earnings, (SDE). Working with discretionary adjustments, compensation data and adjustments, normalization adjustments, working with cash, real estate owned, non-operating and onetime adjustments; Process for verifying add-backs.
Market approach private company guideline method is covered in detail. Topics include the market method formula, reasons to use market method, objections to market method, weighting the cash flow, estimating the multiplier, standard of value for comparables, rules of thumb, using market data databases, private company guideline method, market method multiplier selection process, industry, cash flow, charting and graphing results. Selected transaction method. Multiplier soft factor analysis and presentation; Market method balance sheet adjustments including inventory, working capital, and debt. Statistics in the market method including regression analysis, coefficient of variation.
Overview of asset methods. Topics cover floor value, mark to market, liquidation value. Working with the balance sheet, current assets, fixed assets, built-in gains tax, intangible assets, goodwill, liabilities, personal guarantees, owners’ equity, adjusted net worth.
Application of the two primary income methods for small and very small businesses. Methods are the capitalization of earnings and discounted cash flow. Topics cover who is an investor, implied discount rates vs. market method values with very small businesses. Calculating value using capitalization of earnings, Gordon growth model, cash flow considerations, tax affecting, IRS and tax affecting, suggested tax affecting methods. Cash flow forecasts and projections for discounted cash flow, review of forecasts. Balance sheet accounts and projections, working capital, capital expenditures, debt. Calculating a discount rate, sources of data for calculating discount rates, build up method (BUM), risk premiums in BUM, specific company premium considerations and presentation. Calculating a capitalization rate, growth rate, next period adjustment. Mid-year capitalization rate. Weighted average cost of capital (WACC). Finance method rule of thumb. Discounted cash flow, present value calculations, terminal value, exit multiple approach.
Valuing Partial Interests in a Business
Valuing partial interests is a second valuation of the interest after determining enterprise value. Issues include business rights at the highest level being, management control, cash flow, tax benefits. Unified levels of value for interests including control, marketable minority, unmarketable minority. How to examine the interest’s rights including statutory frameworks, examining corporate documents and limited liability documents, close corporations, employment agreements, enforceability of agreements, state law court cases. Estimating discounts and premiums, calculating the minority discount, calculating the discount for lack of marketability (DLOM) including liquidity discount, qualitative methods for estimating DLOM, restricted stock studies, IRS Job Aid, Mandelbaum factors. Finally other discounts and control premium.
Goodwill and the Small Business
Estimating goodwill and intangible asset value. Topics include calculating goodwill, calculating personal goodwill and types of personal goodwill including pure, transferable, and entity goodwill.
Accounting Issues with Small and Very Small Businesses
Poor quality accounting abounds with small business this chapter has tips on how to work with imperfect financials. Topics include cash, accrual, tax basis statements. Working with cash basis statements such as adjustments for converting cash to accrual, percentage of completion method, working with Quickbooks. Determining accounting cut-offs. Accrual basis accounting issues such as loans, insurance and prepayments, real estate leases, inventory, work in process schedules (WIP), over / under billing, inventory methods. Tax basis accounting, GAAP, Working with CPA produced statements. Valuing from cost or unit accounting data. Balance sheet matters including cash, accounts receivable, inventory, other current assets, fixed assets, liabilities, accounts payable, other current liabilities, long term debt, contingent guarantees, owner’s equity. Estimating adjustments, estimating working capital, estimating capital investment, owner debt, excess assets, and calculating BIG taxes
Details for Business Valuators
Weighting and selection of final valuation methods, standards related issues and more. Details include calculations of value and conclusions of value, valuation reports, calculation reports, AICPA SSVS standards, NACVA standards, USPAP standards. Meeting client needs, determining what matters, and materiality. Law of parsimony, documenting and applying professional judgment.
Assisting the Small Business Buyer or Seller
Tips for assisting buyers and sellers of small businesses. How to ask questions and interview, emotion in small business transactions, what do buyers want, working models, simplicity, profitability; increasing business value, short term value enhancement, mid-term value enhancement, long term value growth strategy. Representing buyers, partner risk and buy-sell agreements. Small Business Administration, (SBA) lending process, underwriting, obtaining loans. Business brokerage, maximizing price, main street business brokerage sales processes, lower middle market investment banking sales process, selecting a business broker. Transaction negotiation tips, qualification, fear of loss, due diligence, due diligence checklist.
How to Review a Business Valuation
Steps and checklist for reviewing a business valuation. Where estimates of value go wrong, major valuation problems, cherry picking, valuation periods, problems with add-backs, cash flow weighting issues, selection of methods problems, balance sheet problems, Soft factor integration into valuation, internal soft factors, people and processes, external soft factors, industry and economic issues. Goodwill, personal goodwill, discounts and premiums. Selection of methods and weighting of methods.
“The value conclusion is the result of the appraiser’s judgment and not necessarily the result of a mathematical process” USPAP Std. 9-5 Comment