There is confusion about the rationale and justification for a formal business valuation prior to taking a business to market, i.e., the value of a business valuation. Selling a business is far different from selling a house or other tangible asset where there exists comparable sales information sufficient to support a value. Unlike real estate, it is not unusual for 50% or more of an operating business’s value to be based on intangible assets such as goodwill, intellectual property, licenses, location, etc.
Two businesses both netting $250,000 can have considerably different market values due to such comparative considerations such as revenue growth rate, equipment condition, customer concentration, intellectual property, barriers to entry, competitive situation, owner’s role, administrative systems, labor and capital intensity, etc. One business may be operating below capacity and the other might require significant capital investment in order to grow. One may have an absentee owner with strong operating management while the other could be highly owner dependent. There can be myriad of business valuation variances for companies that on the surface are quite alike. Attempting to value a business based strictly on market comparables results in an average business valuation that is insensitive to distinguishing characteristics and hidden aspects of the business.
The valuation of intangible assets relies on income-based methods. Accurate discernment of earnings and seller’s discretionary cash flow (SDCF) is essential if the value is to be true. The business valuation process begins with a detailed examination of the company’s revenue and expenses to accurately determine the true earnings performance of the business. Is the brother-in-law earning $50,000 really needed? Is a Porsche Cabriolet necessary for delivery purposes? If the seller owns the building, is the rent at market rate? How much business is being conducted in the addition to the owner’s house that the company’s maintenance crew built? What about stockholder compensation mystique in S versus C corporations? Inventory pricing creativity? Such typifies the discovery challenge of the appraiser and the rationale for a formal business valuation if the company is to be fully valued.
Another major reason for a business valuation is to avoid surprises in the due diligence process, which can quickly kill a deal. Full financial disclosure upfront to a buyer is extremely important. Bad news, if fully disclosed, might have an impact on price but at least the deal is far more likely to survive with upfront disclosure.
With precise earnings information in hand, the appraiser employs several valuation methodologies and weights the various results according to their pertinence to the business in question. For a business with significant tangible assets, the appraiser incorporates those asset values with the intangibles through methods such as Capitalization of Excess Earnings to arrive at a fully integrated value.
Finally, the appraiser subjects the business valuation to an extensive set of qualification criteria from over 100 SBA lenders for further validation of the value. If the value withstands the SBA’s requirements standards, then there is added basis for its validity.
Every business has a range of fair market value—the business valuation process is not totally scientific. The challenge of the valuation process is to determine a business’s true earnings, to assign fair value to its intangible assets and to uncover the hidden value drivers of the business that reside below the radar of superficial valuation techniques.
At George & Company, we have found that businesses for which we have done formal business valuations sell considerably closer to asking price than those without valuations. It appears that both sellers and buyers become better informed as a result of a formal business valuation resulting in a more enlightened process for all concerned.
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