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Business valuation is science and art

By Greg Paeth

Business valuations are a science and an art – a process conducted with an eye out for the thumb of emotion on the scales.

valuation_74926933In mid-August, former Microsoft CEO Steve Ballmer acknowledged he was paying an “L.A. beachfront price” of $2 billion for the Los Angeles Clippers, a traditionally lowly NBA franchise overshadowed for decades by the crosstown rival Lakers, who hold 16 championships.

The previous high NBA franchise price was $551 million paid in 2010 for the Washington Wizards. Then last spring, shortly after former Clippers owner Donald Sterling became mired in controversy, writers began to speculate that the franchise might – just might – be worth as much as $1 billion, a mind-boggling multiple of the $12.5 million Sterling paid in 1981.

“The first thing I thought when I heard it (the $2 billion pricetag) is, ‘Geez, what are the Lakers worth?’ ” said Stefan Hendrickson, a CPA and accredited business valuator with the Mountjoy Chilton Medley accounting firm, Kentucky’s largest with offices in Louisville, Lexington, Frankfort, Cincinnati and Jeffersonville, Ind. “The second thing I thought is that the NBA must have taken care of business (for team owners) in the last lockout (of the players).”

Hendrickson, senior manager in MCM’s Lexington office, made it clear that owning an NBA franchise is quite different from a typical business, the thousands of much smaller privately held companies that can be found in virtually every hamlet and every major city in the country.

“The NBA is kind of a playground industry,” Hendrickson observed. “If you have enough money, you want to get a team.”

If a price can be agreed upon.

Even for the many thousands of private business owners who never take a shot on pro sports’ billion-dollar playgrounds, a precise business valuation is just as critical – or perhaps more so – when it’s time to buy or sell all or part of a company.

Some entrepreneurs launch endeavors entirely to sell them as soon as possible. More commonly, transfers happen because of business burnout, estate planning, retirement, divorce, litigation, the death of an owner, a dispute among owners, a proposed merger or an acquisition deal. Other times business owners will seek a professional valuation because of an unsolicited offer.

“A lot of times (a client will) say, ‘I just got an offer to sell my business, and I want to know if this is right’,” Hendrickson said.

Equities markets set theoretical business valuations for publicly held companies every trading day. But those straight-formula estimations often aren’t the final word; deals do use the market’s numbers but also occur at premiums over equity market price when a buyer has factored in additional variables.

Owners optimistic about valuations

“Anytime that someone has a privately held business where there’s not an open market to sell their shares in, they have to come to someone and get a valuation on the value of that business. That’s where we come in,” said Drew Chambers, a CPA, accredited business valuator and a principal at MCM.

valuation_163204406Like two other MCM accountants, Chambers devotes all his time to business valuation.

The process can be complicated because some numbers can be fairly easy to nail down while others are tough to calculate and can fluctuate wildly. The pricetag on a company’s office building or a year-old color copier, for example, can be determined with some precision. Far more nebulous is the value of something like the “goodwill” that Standard Widgets created in the community by sponsoring a Little League team for 25 years or chairing the annual United Appeal campaign.

Four knowledgeable people who understand the business valuation process inside and out agreed there’s only one near certainty in the process: Business owners usually believe their company is worth more than its actual value.

“What we usually run into is everyone who is a business owner or an entrepreneur is a very optimistic person,” Chambers said. “So we do run into a lot of folks who, when we say ‘Okay, looking forward at your business, what kind of income levels or revenue levels are you going to have?’ most business owners think the next five years are going to be the best ever, and say ‘we’re going to experience growth like we’ve never had before.’ ”

An improving economy may bolster that optimism.

Louisville businesses’ asking prices and revenues increased in the past year, according to BizBuySell.com, which claims to be the Internet’s largest marketplace for businesses that are for sale.

Revenues and valuations have risen

The 77 Louisville businesses listed on the site during the second quarter of 2014 had a median asking price of $300,000, which is an increase of 30 percent from the $230,000 median for 2Q 2013. Median annual revenue was $408,000, up about $66,000 or just more than 19 percent compared to companies listed a year earlier, BizBuySell reported. However, median cash flow declined by $1,700 per year to $80,000.

Rising prices aren’t just a Louisville phenomenon. At the national level, BizBuySell said second quarter activity indicates that 2014 could be a record year for the number of buy-sell transactions since the company began tracking data in 2007.

Chambers and Hendrickson of MCM as well as Dee Dee McLeod, who runs Cycle Strategies in the tiny Louisville suburb of Glenview, all adhere to clearly defined formulas in the valuation process, using one or more of the three distinct methods – asset, income or market – in providing clients with a valuation that can be used as a reasonable starting point for buy-sell negotiations or, in some cases, an incontrovertible figure that both buyer and seller, or plaintiff and defendant, will live with.

Greg Hedgebeth, a business broker who specializes in selling small businesses – $5 million or less in annual revenue – from his Hedge-Financial office in a Cincinnati suburb, addresses valuation questions differently.

“My approach to it is more of the street-smart informal valuation. The true value of a business is what a buyer is willing to pay for it. The valuation process you’re talking about is a more formal process,” said Hedgebeth, a CPA who has been buying, selling and running businesses for nearly 40 years. “But mine is more of an informal actual valuation of what the business is worth on the street versus a theoretical value that’s essentially on paper.”

Hedgebeth, an exit strategy consultant for small to medium-size businesses in Ohio and Kentucky, isn’t dismissive of the more structured approaches and said he has employed those methods in the past.

Chambers stresses that the valuation process should never be confused with an audit, and McLeod agreed.

“I’m not making judgment calls on what they’re doing,” said McLeod, a CPA who is certified by the National Association of Certified Valuators and Analysts. Her resume includes two years as CFO of Louisville’s john conti Coffee Co.

Three main approaches to valuation

Chambers, Hendrickson, McLeod and Marty Zwilling, writing for the National Federation of Independent Business, offered some capsule summaries of the three different methods that are commonly used in valuations:

• Asset approach: Typically involves a detailed examination of what the company owns and determining what that property – from the real estate to the office staplers to the inventory – are worth if they had to be sold. Determining the value of assets is important, McLeod said, but shouldn’t be considered the definitive factor in a valuation. Business owners have to ask themselves whether their operating income is actually generated by those assets. For example, sometimes it becomes clear that “you do not have to have that office building to operate that business,” she said.

• Income approach: Chambers, Hendrickson and McLeod said they routinely scrutinize financials to develop an accurate picture of the company’s health and its long-term prognosis. Chambers and McLeod said the process calls for an examination of the company’s internal financial records – preferably records that have been audited – as well as tax returns. The final report, said Chambers, often involves “taking a historical stream of earnings and projecting a value for future cash flow.”

Certified valuators are required to consider more than one of the valuation methods when they begin work for a client, Chamber said.

McLeod has been working with one client for two years to prepare his business for sale. She likened selling a business to selling a home and emphasized the importance of having comprehensive, accurate financials available to a prospective buyer.

“Quite honestly, (you want them) as clean as their records can be … just like as clean as their house can be – as clean as can be! You don’t want to have to explain a lot about your financials. Your financials should be stand-alone documents that fairly and accurately represent your business.”

Market approach: This method focuses on examining a business in comparison to similar size businesses in similar industries in similar size markets and determining what that business is worth. In many cases, the business will be compared to similar businesses at the local, regional and national level. In some cases, there are thousands of comparables in the country that would indicate, for example, what full-service restaurants with liquor licenses sell for, McLeod said.

“In a theoretical perfect world, all three of your approaches would line up and be very similar in their calculation, but it can vary sometimes wildly because the majority of the businesses we’re valuing are not public companies, they’re closely held businesses, so getting good market information on those companies can be a difficult task, which is another thing to consider when you’re working with a valuation advisor,” Hendrickson said.

And then there’s “street smarts”

Hedgebeth said his street-level approach is based on his years of experience about how the market works when a business owner decides to sell.

“And that’s the whole counseling process I go through when I talk to the seller,” he said. “I pretty much tell them I know what banks are going to loan for a business and I know what buyers will pay. You’re going to pretty much have to say to the seller, ‘This is what your business is going to sell for on the street. Are you sure you want to sell? Is this something you want to do?’ ”

As might be expected, determining the value of a startup can be much trickier because they rarely have well-established histories that indicate what can be expected next year or 10 years in the future.

Because of the dearth of information, Hedgebeth, who typically deals with businesses that have been operating for at least 20 years, said standard “metrics are thrown out with some startups.”

McLeod agreed. “You are going on projections and that gets very tricky,” she said, “especially if (the startup is) a very niche business. It’s really hard to even find anything that’s comparable to that and actually gauge if the industry is ‘growing by 40 percent year over year over year.’ You really have to dig a little deeper and find out how and why they’re justifying these projections and are they realistic.”

McLeod also said that ethical valuators always know which clients to avoid.

“As soon as you walk into a meeting and they say, ‘I want you to value my business and this is what I want it to be worth,’” she said, it’s time to tell them “Thank you very much, but I don’t think we can do business.”

Greg Paeth is a correspondent for The Lane Report. He can be reached at [email protected]