Value Calculation vs. Appraisal: Determining the Best Choice to Value Your Business

Published on: 09/12/2019 By: GSG

If you’re in the process of selling your business then you’ve probably thought about an appraisal. But is this the best option when understanding the value of your business? Possibly, but it isn’t the only option. A value calculation is an additional way to determine an accurate value for a business owner.

In the following Q&A, GSG’s Director of Business Valuation and Litigation Support, Chuck Faunce, explains the differences between a value calculation and an appraisal, circumstances that impact value and additional tips of advice for business owners buying, selling or appraising a business.

Q: I am selling my business, and I am trying to decide whether or not I need an appraisal. When paying for an appraisal, aren’t I just paying for an expert’s opinion?

A: Whether or not they get an appraisal, a business owner should have more than a gut feeling about the value of their business before they start the selling process. Appraisals are one option. Another option is sometimes referred to as a “value calculation.” Both options provide a more formal way for a business owner to better understand the value of their business.

The important distinction between an “appraisal” and a “value calculation” is that an appraisal represents the appraiser’s opinion, whereas a value calculation does not. Moreover, appraisals are required to be developed objectively. Value calculations, on the other hand, can reflect significantly more input from the business owner. As a result, a value calculation may be a better choice to make the business owner’s case to potential buyers regarding the value of the business.

 Q: I am selling my business, and I am ready to have my business appraised. A business similar to mine just sold for a five multiple. Can I just use that the same multiple to determine what my business will appraise for? What additional research will a business appraiser offer me, and how is this research typically done? (For example, through interviews, economic research, competitive research, etc.)

A: While a multiple obtained from a recent sale of a similar business is an indication of value, it’s not necessarily determinative for several reasons. First, the recent transaction begs the question of just how similar the acquired business is. There are many factors that go into that analysis, including quantitative issues like expected growth and profitability and qualitative issues like the strength of customer relationships and depth of management. Second, and perhaps most importantly, without knowing the actual buyer’s and seller’s individual motives and circumstances, and without putting that individual transaction (singular) in the context of a marketplace of transactions (plural) it’s hard to know whether that multiple is too high, too low, or just right.

A valuation can help to answer these questions. Whether it’s in the form of an “appraisal” or a “value calculation,” it provides a process for a business owner to better understand the value of their business. Through discussions with the business owner and independent research, the analyst obtains information regarding the historical, current and prospective nature of the business, the economic and industry conditions in which the business operates, and the capital market conditions in which the transaction will occur. This information is then considered in the context of the three generally recognized approaches to business valuation, which are the Asset Approach, the Market Approach and the Income Approach. The values calculated under the three approaches are synthesized to yield a range of values or a point estimate of value.

 Q: Do banks require a business appraisal when offering financing?

A: Whether or not it’s a requirement, providing the bank with a credible appraisal of the target business improves a buyer’s chances of obtaining a loan to fund the acquisition.

Q: I am having issues with my landlord and may not be able to extend my lease. Can this impact the value of my business?

A: Yes. If any buyer would be forced to relocate the business, it would be reasonable for the expected costs, including the effects of disrupted operations, to be deducted from the purchase price. To the extent the effect of disrupted operations could be significant, potential buyers’ perception of the risk associated with the business could increase. In order to accept this additional risk, a buyer would require an additional reward, which they would likely seek to obtain by further lowering the purchase price.

Q: I had a major flood and my business was closed for two months. How will this impact my business appraisal?

A: Past events impact the value of a business to the extent they can be expected to recur and to the extent their effect lingers. Lingering effects of a flood could reduce value by reducing expected future cash returns to the owner. The possibility of recurrence could reduce value by increasing the uncertainty regarding the timing and amount (i.e. the risk) of expected future cash returns.

 Q: My assistant stole $300,000 from my business. How will this impact my business appraisal?

A: Significant employee theft indicates an absence of sufficient internal financial controls, and has several negative effects. First, it calls into question the validity of the business’s historical financial information. Although it may be expensive, this effect can be at least partially mitigated by obtaining audits of the business’s books and records for several years prior to the transaction and restating the financial information if necessary. Second, to the extent any financial information restatements are significant, loan covenants as well as customer and supplier agreements could be affected. Third, upgrading people and processes to reduce the possibility of future theft can be expensive and time consuming. All of these issues would likely have to be resolved by the current business owner prior to starting the process of selling the business as potential buyers won’t pursue an acquisition if they don’t have confidence in a business’s financial information, people and processes.

Q: My key manager is planning on leaving the business. He may be difficult to replace. How will this impact my business appraisal?

A: The loss of a key manager may reduce the value of a business. In fact, even the possibility of losing a key manager may reduce the value of a business. If any buyer would be forced to replace a key manager, it would be reasonable for the associated costs, including the effects of disrupted operations, to be deducted from the purchase price. To the extent the effect of disrupted operations could be significant, potential buyers’ perception of the risk associated with the business could increase. In order to accept this additional risk, a buyer would require an additional reward, which they would likely seek to obtain by further lowering the purchase price.

Q: Should I wait for my patent to be approved before getting my business appraised?

A: Not necessarily. Business valuations are forward looking and so reflect expectations about the future. Since appraisals identify and provide support for significant value drivers, the effect of prospective patent approvals can be incorporated into the analysis. However, if the effect of the patent on the business is expected to be large, and if approval of the patent is uncertain, a separate technical analysis of the patent application may be required to satisfy the concerns of prospective buyers.

Q: I am losing a major customer that generates about 10% of the revenue for our business. How will this impact my business appraisal?

A: It depends. It’s not uncommon for businesses large and small to have customers that generate 10% of their revenues, and it’s not uncommon for businesses to experience some amount of turnover in their customer base. Further analysis would be required to assess whether that customer is more or less profitable and more or less resource intensive than other customers. While one might expect losing a customer to be a bad thing, that’s not always the case.

Q: How can a potential or pending lawsuit affect the value of my business? Should I resolve this before getting my business appraised? What happens if one arises after my business has been appraised?

A: The possibility of receiving an adverse judgment in a lawsuit represents a “contingent liability,” and contingent liabilities can reduce the equity value of a business. If a lawsuit creates enough uncertainty, resolving it may be necessary to keep an equity sales process on track. On the other hand, a lawsuit may not affect an asset sale if it does not encumber the business’s operating assets. The purchase price in an asset sale may even be higher than an equivalent stock sale because the buyer may be able to reduce their future taxes by amortizing the purchase price.

Q: Do you have any other tips of advice for anyone buying, selling or appraising a business?

A: A lot depends on the facts and circumstances, but generally – make a plan and work the plan.

For more information about determining the best value whether you’re looking to buy, sell or appraise a business, please contact us.

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