How can you tell if a business valuation is correct or if it is likely to be biased, wrong, or outright rigged?
In the majority of business valuations, the business valuator follows accepted standards and delivers a supportable and unbiased valuation.
Unfortunately, a few business valuations are incorrect or inappropriate. Often this result is more because of inexperience or unrecognized bias rather than outright intention.
The wrong standard of value. Standards of value are standardized assumptions around who are the agreed upon buyers, sellers, timing, and other details of a sale. The wrong standard of value will subtly change many things in the valuation and often lead to an improper value.
The wrong valuation date. The valuation date is the cut-off date that the valuation is done through. For some valuation purposes the valuation date is critical. For instance, consider the value of a restaurant serving a tourist destination on a far-off island the month before Covid-19 shut downs and the month after. For some purposes the valuation date moves. This is common in divorce. The wrong valuation date can result in a wrong value.
The cash flow being applied against the wrong multiplier or discount rate. For instance a SDE (Sellers Discretionary Earnings) cash flow being applied to an EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) multiplier; a non-tax adjusted cash flow being applied to a standard tax adjusted build-up. This can greatly skew value and is not always as obvious to spot as it sounds.
Too Good To Be True, almost miraculously better or worse current year (or previous year) results than earlier periods. In some industries, many aspects of the accounting statements are based on allocations that can be tinkered with. Are gross margins consistent, were all expenses entered, are the period cut-offs correct? Does the economy, industry, company factors and more support the numbers? There may be a very good reason for the change in results, but make sure the situation makes sense.
Suspicious add-backs, one-time events, and so on. Adjusting entries to create “apples to apples” financial statements for comparisons to market data or discount rate data is essential. It is also a major area for error and trouble. Make sure comparability, one time, and discretionary adjustments meet the definition for the cash flow being used and are properly supported.
Cash flow weighting that is not supported by facts. Both the market method and the capitalization of earnings method weight historic cash flows to estimate a future cash flow value. This weighting should be done to tie into expected future results as reasonably influenced by the past and future expectations. Intervening events can make historic cash flows susceptible. This calculation is easy to miss and can greatly swing results.
Hockey stick projections. Similar to miraculously better financials are projections into the future. Companies that claim they are going to “take-off” next year. Certainly that could happen but support should be very strong and the discount rate should be higher to justify a value found.
Unusual or doubtful discounts, capitalization rates, and market data multipliers. These are all adjustments to reflect the risk of making or not making the required cash flow return into the future. The comparison set needs to be reasonably tied into the situation with the subject company. While the discount rate or multiplier is a simple number, estimating it requires experience and professional judgement.
A final value after all adjustments and balance sheet adjustments that is above a 100% financed business at 8%. This is extreme, but it happens, most often with very high inventory or receivables businesses. Again, the finance method is a great sanity check. In the Finance Method rule of thumb, you work back from the cash flow to estimate the loan principal amount it will support.
Cash Leakage. At the other extreme, a long-term high revenue business in a “cash” industry with very low gross margins and no value. While it could be a huge discounter, it may also indicate cash leakage and requires additional review.
Cherry picking. Namely, almost every choice was favorable to very favorable for a higher or lower value. Consistent but unjustifiable small gains or losses at every turn can greatly change the value found.
All of these issues, other than the first two issues, could be explainable and even correct. But, if these factors are present, look hard and ask questions before signing that the value found and the report is correct.
Conclusion:
If you are reviewing a business valuation you should make sure it is correct. The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has 400 pages covering many professional judgement, calculation, standards, and other important valuation issues along with access to sample reports, calculators, and checklists downloadable from the web. This will be the one book you will reach for if you value or rely on valuations of micro or small businesses with revenues under $10 million. The book published by Wiley is available at your preferred bookseller. More information can be found at www.theartofbusinessvaluation.com
Finally Greg Caruso, JD, CPA, CVA, the author is always available to prepare (or review) business valuations for all purposes and situations.
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Recently I presented “Valuing Micro and Small Businesses in the Shadow of COVID-19″ as a webinar training for Business Valuation Resource members. As always, I provided time at the end of the session for questions from attendees. This group had some very thoughtful questions. I thought perhaps others would benefit from our discussion.
What do you mean by “poor financials?” Do you mean a lot of personal stuff is run through the business? Or a general ledger that doesn’t balance and off balance sheet assets / liabilities?
Each of those issues creates poor financials plus many more. Many micro and small business owners manage by walking around. They have a few leading indicators they watch (maybe sales, collections, production). From those, plus being in the middle of the business, they know how they are doing. This knowledge does not translate well for us, as we are not in the middle. Therefore, we have to work harder to really understand what is going on and how to adjust the deficient financials so they are reasonable and workable.
What sources of data do I use for the local economy?
I use the Federal Reserve Beige Book, published for each district. It is anecdotal information but I find it useful.
Another one I will use for cyclical and real estate related is State Board of Realtors sales data. Often this can be obtained at a local level, if that is more meaningful for your company. The data here impacts everything from construction, remodeling, furniture sales, equipment sales, etc. in a local or state market.
Also, the quarterly BizBuySell Insight Report offers data on many market areas with prior reports available for many years to allow comparisons. The number of sales can be used as an indicator of the difficulty or ease of selling a small business.
Local information can be gleaned from many sources. Many federal agencies, states, universities, and state oriented non-profits publish data that might be indicated for the Company and industry you are valuing.
I have been spending more time analyzing debt service (for example: Can they pay back the debt? If so when will they achieve a profit given high debt levels? Will they need more debt to stay afloat?). Do you have any thoughts on that?
Certainly for high debt companies, or companies with lumpy cash flows, (i.e. a few large clients or projects that have endpoints like construction contractors that do a few large projects each year) understanding the balance sheet is very important. Current assets on the balance sheet (particularly cash reserves) provide resiliency and the ability to meet payments when times are tough.
Another thing that needs to be reviewed with companies with debt is the terms of the debt. Many small companies use lines of credit like long term financing. Also, even long term loans often contain clauses allowing the lender to recall the entire amount due, if covenants like minimum earnings are not met. The result can be a company that is meeting minimum cash flows to survive falls into default on their loans creating serious going concern issues.
In most cases (but not all), we do not have data to make a final determination on going concern issues. But a company that has a reasonable level of going concern issues is going to have a steep discount versus companies with a clear path forward.
I saw a few companies with low, negative earnings (-30% to 50% and high revenues multiples in the range of 3-4x. This looks funny for a service company. Since I don’t have historic data or projected data how can I make sense of the pricing relationship?
Without more data, I’m not sure. And perhaps you can’t. Some technology codes do have the types of companies desired by Google, Apple and the like and these may contain synergies that frankly I don’t completely understand how to assess.
Assuming there are enough comparables, I recommend several things though before you throw up your arms in defeat.
Try sorting the data several ways. Use different cash flow minimums and minimum and maximum revenues and see if the results look different. Sometimes I get an understanding of the data doing this and it is easy within the DealStats .
Assuming your firm is profitable sort with a minimum cash flow that is somewhat near your cash flow (i.e. if your company as a 15% SDE profitability (SDE/Revenues) and a minimum revenue sort of $1,000,000 then perhaps you require an SDE of $75,000. Since your company is profitable, these comparables will be more like your company.
Always chart the companies by cash flow profitability (Cash flow being used/Revenues). This will usually provide clear trends that are different from what might be implied by the charts shown in the various databases.
Three more webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic are scheduled in the upcoming weeks.
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
This month’s Business Valuation Update published by Business Valuation Resources (BVR) featured my article about implementing a “COVID-19 Marketability Discount”. This is a Discount for Lack of Marketability (DLOM) that arises due to an unusual amount of risk because of COVID-19 and the related economic fallout affecting small and micro businesses.
The methodology used to determine a COVID-19 Marketability Discount can be applied as a separate discount or it can be used as a basis to adjust the historic information based market method multiplier or income method company specific risk premium (SCRP). In many current situations, due to the risk presented by COVID-19, our historic data sources (market method data bases and income method build-up data (BUM method)) do not adequately address the short term risk that is currently being placed on small businesses and their valuations
Micro and very small businesses generally cannot provide forecasts. Therefore the valuation analyst has to use a single period valuation method. As is always the case, the cash flow should be adjusted to reflect the most likely future. But, if the analyst believes an economic recession or 2nd waive of the virus could further impact cash flows there is likely to be more risk to these future cash flows than that reflected in the historic data. Assessing that risk and making an appropriate adjustment is the purpose of this COVID-19 Marketability Discount.
Alternative method: In a new article, an analyst reports that he has been using a “COVID-19 marketability discount” on control interests to make the extra risk adjustment.
“In many situations, I favor the methodology of showing a separate COVID-19 marketability discount,” says Greg Caruso (Harvest Business Advisors), “because it clearly shows the valuator’s thought process and the actual discount being applied for the current high level of uncertainty.”
His methodology is based on the weighing of factors such as those used in Mandelbaum and the IRS DLOM Job Aid but with categories modified to fit the current situation.
Caruso first developed this technique to use in a valuation for an SBA loan. The company was temporarily shut down and appeared to be fully recovered on a monthly cash-flow basis for the two months after reopening. Yet, there was still risk of another shutdown and customers would have economic issues if a recession hit, so Caruso’s basic capitalization rate was a buildup for “normal times,” which included a normal company-specific risk that he further discounted by the COVID-19 marketability discount.
Caruso explains his methodology and presents a case study in more detail with a sample analysis in the November 2020 issue of Business Valuation Update.”
I am grateful to BVR for their support through the years. They are truly a valuable resource.
In the upcoming weeks, I will be conducting several webinars on this topic. Please visit the Events Page for more details.
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has over 400 pages covering many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller or directly from Wiley.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
The following are quotes related to small business valuation, business owner succession or exit planning, business brokerage, SBA and more from “The Art of Business Valuation, Accurately Valuing a Small Business,” by Gregory R. Caruso, published by Wiley, 2020, ISBN: 978-1-119-60599-7
You are authorized to use these quotes by providing the following reference to the book, Caruso, Gregory, “The Art of Business Valuation, Accurately Valuing a Small Business”, 2020 Wiley, along with the page number. If there is not a page number, then it is just a quote of the author, Greg Caruso. If possible referencing this website www.theartofbusinessvaluation.com is always appreciated.
Micro and Small Business Valuation in the age of Covid-19
“Small business is under unbelievable stress from Covid-19 related economic issues varying from shut-downs to product shortages. Business valuation is based on future cash flows of the business. Micro and small businesses have a difficult time projecting cash flows in stable times which has become greatly magnified in the current environment. Yet outside a few “loser” industries and locations good businesses and good business people will preserver and create business value. As business valuators our job is to apply valuation basics along with professional judgment to properly assess business value and assist owners in growing that value particularly in times of uncertainty” Gregory Caruso, Author, “The Art of Business Valuation, Accurately Valuing a Small Business,” Wiley 2020
“How does one equate a large number of deaths, 10%+ unemployment, and a soaring stock market (at least as of August, 2020) when trying to predict the future cash flows of a small local business?” Yet this is what business valuation analysts do. The reliance on basic valuation principals augmented with professional judgement is how we value micro and small businesses in this environment. After all, business people will continue to need business valuations to buy, sell, get divorced, obtain loans etc. even in these uncertain times. Gregory Caruso, Author, “The Art of Business Valuation, Accurately Valuing a Small Business,” Wiley 2020
What creates errors in business valuation?
“Most major errors in business valuation are the result of missing facts or patterns and misinterpreting those facts or patterns, not from the improper application of the model. For instance, failing to factor in falling fuel prices into a bus company valuation that results in a very high valuation. P.26
Why is it hard to prepare a business valuation for Main Street, micro, and very small businesses?
“Small and very small businesses are just not very good at data collection, much less providing it to third parties. Most small business owners manage by walking around. In addition, the best owners have a few indicators that tell them where they stand; perhaps incoming orders and cash balance; perhaps today’s cost of goods. They have their one or two simple indicators and a feel for the business. This way owner/operators can run great businesses and keep overhead down. While this limits long-term growth, it creates significant overhead efficiencies. Consequentially, this lack of data makes economic and business sense.” P. 29
What is the Art of Business Valuation?
“No matter how complex a company or situation may seem while working through a valuation, when complete, the valuation analyst should be able to provide a concise and clear analysis. If the analyst cannot do that, then more work is needed. Being able to simplify is a major indication that you are achieving the Art of Business Valuation.” P.37
“Small businesses have less quantifiable financial data. Therefore, more reliance must be placed on qualitative, or soft data. This requires more professional judgment, hence, Art in performing a business valuation.” Gregory Caruso, Author, “The Art of Business Valuation, Accurately Valuing a Small Business,” Wiley 2020
Importance of business systems
““Quality business systems are when average people get extraordinary results every time.” Use this as the standard to determine systems. One indicator is if there are, “lots of reasons why things are not working,” generally, their systems do not work. P. 52
Importance of people to business value
“Does the business have a culture of: “forever and continuous improvement” or resiliency in the face of problems?” These two factors often are the biggest indicators of future success or failure. They also are cultural matters that may be hard to quantify.” P.55
Why is small business more risky than larger businesses?
“Concentrations kill. Concentrations are the main reason why small businesses are so much riskier than larger businesses. A large customer or supplier or other concentration can cause major disruption and bankruptcy when relationships end. Small and very small businesses have all sorts of concentrations. Many concentrations are unavoidable at least for periods of time. This include, customer concentrations, product concentration, supplier concentrations, referral concentrations, geographic concentration, key people concentration, commodities risk concentration.” P.60
Valuation Discounts, (Primarily Lack of Control and Marketability Discounts (DLOM))
“The purpose of a discount is to fully factor adjustments between the interest being valued (usually partial ownership) in the subject company and the comparables that are not fully accounted for elsewhere in the valuation model. Discounts are even more justified with small and very small companies due to the high levels of risk because of owner relationships, limited customers, limited suppliers, small geographic market, limited management depth, etc. These concentrations create volatility and risk that do not exist with larger companies and often are not fully accounted for in market data, capitalization rates, and discount rates.” P. 252
Exit Planning For Business Owners
“Many employees when asked, “Would you like to be an owner?” hear, “Would you like an upside bonus plan?” not personal guarantees and real ownership risk. This requires a clear and detailed conversation – early.”
“One area that could use more focus is the emotional side of the business exit and purchase process. Buying or selling a business is a major life change. It is stressful and difficult for most people. Numbers are easy compared to emotion and fear. Therefore, most people, even those who should know better, just avoid the topic.” P. 318
“Owners are sellers when their TIME is worth more than their MONEY. Most owners are not sellers because their business is how they want to spend their time. Their business is worth more to them than other potential owners. That is why business brokers are so concerned about what owners are going to do next. The void of time becomes bigger as closing gets closer.” P.324
What business buyers want
A “working model” to generate the cash flow. This means systems that work today. People who can operate the systems today who are staying after the sale.” P.325
“A very clear buyer adage is, “If you want to be paid for it, prove it.” In other words, buyers pay for what exists. An apple seed has the potential to be an apple tree. But no one pays for the tree when they are getting the seed.” P. 325
SBA 7(a) Business Loan Program
“Prior to the SBA most small transactions required the seller to finance as there was no one else…… This is rarely necessary with cash flowing businesses any more. In the last 25 years the SBA has removed these issues and brought stability to the market.
It appears that part of the reason why transaction sale data has become more useful is because there are more consistent transitions. In the end, most sellers take the SBA’s loan amount and the sale price is reasonably close to the loan amount. Few sellers want the risk associated with providing financing. The availability and stability of financing have brought predictability to the small and very small business sale market” p. 337
“Should the SBA program be restricted or if the terms for obtaining an SBA loan become very restrictive (for instance, requiring 35% down instead of the current 10% down), the value of small and very small businesses will be greatly impacted. This is yet another assumption underlying most small and very small business valuations that no one even thinks about.” P. 338
Business brokerage in the business sale process. How to maximize a price?
“The point of the business brokerage process is to make a market across the likely buyer pool for the business…… The goal is to get three or more LOI’s (Letters of Intent or preliminary offers) at about the same time to allow negotiating power on behalf of the seller and to verify the market….. Fear of loss brought on by multiple bidders is what creates negotiating power.” P. 345
“Businesses are selling current cash flow. Many a seller becomes so focused on the sales process that their profits fall, reducing value. A good business broker minimizes this distraction. After all, sellers need to run their businesses like they will never sell.” P. 350
Reviewing a Business Valuation
“Finally, does this make sense? Given the overall fact pattern, would someone pay a price that reasonably relates to the value found, based on the facts both specified and the reasonable assumptions with what was known or knowable on the valuation date?” p.394
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has over 400 pages covering many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
Greg is available for interviews, podcasts, quotes, presentations and more. Contact Greg at or 609-664-7955.
Standard of value is a shorthand for describing who is the buyer and who is the seller and what is the framework for the transaction in a business valuation.
For instance a race car has a very different value to a race car driver than it would to a family of six looking for a safe car. The value is also likely to be different if the seller must sell in a week or has three months to make a deal.
While this distinction can be subtle, it can shift the found value significantly. For instance a Fair market value and fair value valuations regularly have a 15-30% or more value variance. A brief explanation of the primary (but not all inclusive) standards of value follow.
Fair Market Value
“The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Rev. Ruling 59-60.
Other important points that, while not in the above definition, are agreed upon by the valuation community:
This payment is in cash or immediately available funds (which means it will be cash within three days). Basically this is a typical buyer and a typical seller transaction at an all cash price.
The buyer and seller are hypothetical not the actual parties.
Finally fair market value is often not the highest price that might be obtained. It is a likely price by a financial buyer with no synergies unless many buyers have the synergies.
The fair market value standard, when used to value minority and lack of control interests, will require discounting or other adjustments. The owner’s of these lack of control interests do not have the ability to control the company, (the difference between being the driver of the car and in the passenger seat) hence their shares are difficult to sell and garner much lower prices than control owners. Discounting is, in effect, a second valuation that reduces the value found from company value to the specific minority owner’s interest value.
Fair Value
Definitions vary, but for litigation and state law purposes, it is usually the fair market value of 100% the equity interests in the enterprise that are then divided pro-rata based on ownership percentage. There are no discounts for minority interest or discounts for lack of marketability for lack of control shareholders. Again, these are the discounts that arise from being “along for the ride” instead of in control of the company. State statutes and in litigation by courts of equity frequently use Fair Value to protect minority shareholders. (Please Note: Fair Value in GAAP public accounting has a different definition but that is rarely applicable to small and very small businesses and will not be addressed here.)
Synergistic Value
Synergistic Value is the value to a buyer where the buyer can make more money from the acquired company than the acquired company could on its own. Consider two delivery companies with half empty trucks going on the same routes. Surely if one acquired the other the successor would be more efficient and profitable. This is Synergistic Value.
If there are many synergistic buyers, then synergistic value may actually equal fair market value. If synergistic buyers are rare, then fair market value will be below synergistic value.
Investment Value
Investment Value is a market value where the buyer and seller are known. This valuation would attempt to use actual revenues and expenses to determine cash flows from the two companies. Investment value may be synergistic or not.
Remember fair market value is NOT the actual buyer and seller but a representative hypothetical typical buyer and seller.
Liquidation Value
Liquidation Value is the value of the assets that must be sold in a defined time frame. Orderly liquidation assumes about a 90 day sales window. Assets must be sold promptly but there is some time to make a market. Forced liquidation is also known as auction value, the price when the asset will be sold on a set date.
Clearly the standard of value selected will greatly impact the value found in a business valuation.
Do you need a valuation for your business or for your clients?
Do you prepare or review business valuations?
Do you advise business owners based on business valuations as their attorney, accountant, or financial planner?
Do you ever refer your clients to a Certified Valuation Analyst?
