In the business valuation profession, one determines Fair Market Value through analysis of the company and its management structure, the industry in which it participates, economic conditions and trends present in the industry, competitive environment, and any other factors that help to define the risk of investing in the enterprise. This analysis of risk is what many in the appraisal profession term as the subjective part of the valuation analysis, or “the art” of appraisal analysis.
The other part, which is the “science” component, is the financial analysis of the company. A proper financial analysis includes looking at the historic income statements, balance sheets and financial ratios to identify trends and see how the company performs relative to its peers in the industry. The next step is to normalize these financial statements to remove non-operating items, non-recurring items, and to adjust the compensation and perquisites of the owner to market rates (also known as control adjustments).
When these analyses are completed, the analyst usually determines a base year sales, earnings and cash flow forecast to capitalize (income approach) and apply market-derived multiples (market approach) to obtain indications of value. The last step in the process is to reconcile the various indicated values into a conclusion of value based upon the analyst’s confidence level in each of the methods used in the analysis.
I regularly appraise small businesses ($1 to 10 million revenue) for SBA 7(a) business acquisition loans, where the buyer and the seller are usually individuals or families. In doing this work I see the transactions that made it through the lender’s screening process, and I see the original asking price and the actual price paid. In most of these deals a business broker did a good job helping the seller set and achieve a fair price. Successful business brokers undertake the same steps that I outlined above to advise their clients before the sale.
I also see some of the deals rejected by lenders and I get to dissect past deals that no lender or appraiser ever touched. What I have observed is that sellers who sell a business on their own or work with a broker who short cuts the valuation process, often end up frustrated. They either leave money on the table, or end up financing most of the transaction and don’t get paid, or they waste valuable time and energy trying to sell for an unreasonable price.
When this sort of thing occurs the price paid or offered usually did not equate to Fair Market Value.
And sellers understandably have a difficult time evaluating brokers because they have no training or experience in this area. Like any major financial transaction, we usually receive more in the end when we rely on qualified and experienced advisors from the very beginning.
For further information or to discuss a current need, Email Bob Altieri, CBA, or call him at 530-478-9790.