Value Blog

The transaction databases that I use in the process of valuing businesses generally reflect that there is a discount for all cash deals.  Sellers are usually willing take less money if they get it up front.  I discussed with Marty Fishman, a business broker with Transworld Business Brokers, whether the way a buyer pays for a business changes the price.

There are generally three ways that a buyer can finance a transaction:

• Pay cash,
• Lender financing with some buyer cash, or
• Seller financing with some buyer cash.

The lender financing is financing from a bank based on the business operations and its assets, usually through an SBA program.  When buyers use home equity loans to finance businesses, the sellers view the transaction as a cash transaction.

Even though a seller receives the purchase price in cash in lender financed deals, the buyer does not usually receive a discount.  This is because the types of businesses that qualify for lender financing are sound businesses with good records.  The businesses may even have tangible assets which are part of the deal such as equipment or inventory.  Many of these businesses are even pre-qualified for financing, making them more in demand and more marketable.

So what does this mean in terms of the price that a buyer will pay for cash?  Cash deals are discounted between 5% and 20% according to Mr. Fishman.  The amount of the discount depends upon a number of factors.  Perhaps top of the list is the motivation of the seller.  Motivated sellers are willing to lower the price to sell the business quicker.  Cash deals will often close quicker than financed deals, with less risk of the deal falling apart.   The better businesses have lower discounts;  businesses with poorer records or that have been experiencing downward trends will have higher discounts for cash buyers than more profitable businesses with good records.

The bottom line is that buyers who get a discount for offering cash can negotiate based on the condition of the business and how motivated the seller is.  Good negotiators may get a better deal by understanding the business.

©2010 Florida Business Valuation Group

After speaking to Marty Fishman, a business broker with Transworld Business Brokers, about what buyers are looking for he had the following insights: “Most buyers approach the purchase with a certain level of skepticism. Buyers want solid facts and believable information that a business opportunity is a solid investment. They want information: financial documents, business operation and facility information. Some of this information will be provided prior to an offer and some of it once there has been an executed purchase agreement with contingencies such as the complete and satisfactory review of property, books and records.”

This is in line with the things that I evaluate as a business appraiser that support the value of a business.  Those businesses with good records and documentation of business operations are worth more than businesses that are lacking.  I will go a step further to say, businesses with limited records are significantly less marketable than businesses with good records.

Since buyers approach businesses with skepticism, consistent records are also important.  As a consultant, I advise clients to rely upon tax returns that have been filed with the IRS under penalty of perjury, over hand written documents that track sales.  In cases where cash sales were not reported on a business’s income tax return (or sales tax returns), there may be inadequate documentation of the amount of unreported cash, leaving the buyer with the difficult decision of accepting the seller’s representations on faith.  I advise clients to consider that if a seller was less than truthful in reporting income to the IRS or other taxing authority, how does one know he or she will be truthful in the amount of unreported cash to the buyer.

Mr. Fishman pointed out “The selling and buying of a business is a very complex process. It involves many aspects that most successful business people are not exposed to in day-to-day operation of a company. Both parties should rely on experts trained in the sale of businesses.”

It is important to keep in mind that when you are buying or selling a business, the price is often based on a number of factors, and the buyer and seller may value the business differently.

©2010 Florida Business Valuation Group

The value of a business generally includes the value of all of the tangible and intangible assets owned by the business. Whether the value of the business includes all of the assets (and liabilities) of the business will depend upon a few things.  First, either the equity (stock or other ownership interest) that owns the business can be valued or the assets used in the business can be valued.  The general rule is: buyers want to buy assets and sellers want to sell stock.  Sellers want to sell the stock or other ownership interest mostly for tax purposes.  Whereas, buyers want to buy assets for tax purposes, but also to avoid potential liability associated with the entity.

The purposes of a valuation will often dictate what is included in the value. For estate and gift tax purposes, the value is of the stock or equity interest owned.  For transactions, the value may or may not include all the assets and liabilities.  In transactions, the purchase agreement usually specifies which assets and liabilities are included in the transaction.

It is important to distinguish between what is included in the value and what is included in different multiples based on market methods methods.  For example, the multiples from BIZCOMPS®, a transaction database, are assumed to be asset sales which exclude cash, accounts receivable, accounts payable and inventory.  Other operating assets such as the equipment used in the business are included in the value arrived at using BIZCOMPS® multiples.  Multiples from the Pratt’s Stats® database, on the other hand,  are for both asset and stock sales, as indicated for each transaction.  Some transactions include the working capital of businesses while others do not.  Transaction multiples from the Pratt’s Stats ® database need to be examined for the details of each transaction.

Within industries, there are often rules of thumb used by business brokers to estimate the value of business.  Different industries treat the assets differently. Beer taverns, according to the Business Reference Guide, sell for 6 times monthly sales plus inventory OR 1 to 1.5 times annual earnings before interest and taxes OR 55 percent of annual sales plus inventory.  Other types of establishments that sell alcohol have different multiples and treat the assets differently.  Rules of thumb for cocktail lounges either add inventory back, add liquor license and inventory, OR add fixtures, equipment and inventory.  As illustrated, different multiples from different sources result in values that need adjustments for different assets and/or liabilities.

So what does all this mean?  A business valuation will clearly state whether the stock or equity interest in a company or the net assets are being valued. If a business valuation has not been done, understand the value from the multiples you chose.  If necessary adjust for assets and/or liabilities which are not included.

©2010 Florida Business Valuation Group

The straight answer is you may not.  Unless the transaction is between family members or will be financed with an SBA loan, a valuation is usually not required.

The advantage to a business valuation is it provides the user with the value of a business or interest in that business.  The advantage to a business valuation is also the major limitation.  The business appraiser will usually provide a single value, based either on fair market value or investment value.  (See blog post here)

Value is a range, though, and there are many different types of value within that range.  As a buyer, you are only concerned with the lowest value within that range that you can pay.  If you can negotiate a lower price than fair market value, you will.

Valuations can be expensive.  If one is not necessary for you to negotiate a deal, you should not pay for one.

The seller has established a starting price for your negotiation.  What you need to determine is whether the cash flow from the business can support that price.

Each buyer has different criteria for whether a deal will work for him or her and there is no right answer.  The things that buyers should consider include:

• What is your risk tolerance?
• What is your required rate of return?
• How long are you willing to wait to get your investment back?
• Will cash flow from the business be sufficient to pay off any debt used to buy the business?
• Will cash flow from the business be sufficient to pay your salary if you are working in the business?

These questions will provide you will the information to determine if the asking price meets your criteria as a buyer.  A business may be worth $100,000, but a particular buyer may not be able to afford the asking price.

Price is the negotiated amount for a particular transaction.  While you need information to make an informed decision, a valuation will not necessarily give you that information.  Your financial professional should be able to assist you in determining whether the asking price of a business meets your criteria.

© 2009 Florida Business Valuation Group

A recent article in the Journal of Accountancy, “Four Options for Measuring Value Creation”, brought up some very good points regarding why the financial statements of a company are flawed as measures of value. The article lists a number of reasons, but top on the list is that value is future oriented, whereas most of the measures on financial statements are historically based. Value is based on anticipated future benefits.

So what does a balance sheet tell you about a business? A balance sheet typically has the historical net cost of the assets a business has acquired over time. The balance sheet does not tell you the type of assets, their age or condition. Older assets may be depreciated and have a very low book value, but still be fully functional in the business. The balance sheet does not indicate what future capital expenses will be to either replace old equipment or to support future growth. Intangible assets, including intellectual property and goodwill, are usually not reflected on the balance sheet even though they may have substantial value.

A balance sheet reports the liabilities of a company. Unless you are reading footnotes to the financial statement (assuming the financial statements have footnotes), the balance sheet usually does not tell you the terms of the liabilities or when they mature. It also does not reflect how old the payables are or whether the company has unused lines of credit. Understanding the obligations of a company is necessary in understanding its value.

Is value better reflected on the income statement of a company? Many people think that profitability, which is reflected on the income statement, the primary element contributing to value. There are two potential problems with this assumption. First profitability is not the same as cash flow. For example, necessary investments in capital expenses for new equipment can impact cash flow while having a minimal impact on profitability. The other issue is the assumption that the level of profitability reported will be sustainable. A business can have increasing sales over a prior year, but if its receivables are increasing at a faster pace, there could either be a problem with collections or the growth may not be sustainable.

Financial statements provide important, but limited information about a company.  Understanding the financial statements is only the beginning in the process of determining the value of a company.

©2009 Florida Business Valuation Group

One of the approaches to valuing a business is the market approach.  This approach looks to either private transactions or publicly traded stock to develop an indicator of value, usually in the form of a multiple.   Is a single transaction representative of the value in the market?

With public companies, the marketplace allows for buyers and sellers to negotiate each transaction by using bidding system.  A buyer will indicate what he wants to pay for a stock and a seller will indicate what he wants to sell the stock for.  When buyers and sellers are matched, there is a sale.  The public stock exchanges provide an efficient system for trades.

When a public guideline company method is used to value a business, comparable companies are identified and the information from the market is used to develop a market value.  Because the data captures the prices paid in the market, it is considered to be a good proxy of fair market value.  Since there are many transactions for each company, it is not necessary that an appraiser use a large number of comparable publicly traded companies in applying this methodology.  (The IRS heavily favors using publicly traded companies as a basis for value in developing opinions of value.)

When comparable publicly traded companies are not available, we look to private markets.  Private markets are no where near as efficient as publicly traded markets.  Often, limited information is available about the sale and the company operations.  Private companies are not require to report information and most information available is from database services that collect the information from brokers and intermediaries.

Since private markets are not efficient, the sales prices usually reflect an investment value rather than fair market value.

With all these challenges, how do we use these private transactions to develop indicators of fair market value?  Using private transactions is based on the concept that when transactions for similar companies are looked at together, these values represent the market as a whole.  The values for companies sold at distressed prices offset the values for companies sold at premiums, resulting in a market value.

Since the private transaction methodology relies upon a group of transactions to extrapolate multiples representative of the entire market, it is necessary to have a sufficient number of transactions to achieve this.  The problem is there is no absolute number.  We know that you need more than five transactions to get a statistically valid multiple.  Most agree that you need more than ten transactions.  The obvious answer is the more the better. With more transactions, an appraiser is better able to analyze the data into groups and arrive at a multiple based on factors that are similar to the company being valued.

While a single transaction price may be representative of fair market value, it is not sufficient to prove fair market value.  Remember price does not necessary equal value.  Price is the negotiated amount at which a transaction takes place and can be influenced by non-market factors.

For more information on the market approach, click here.

©2009 Florida Business Valuation Group