2000 Monthly Newsletters
December 11, 2000 - Discounts and Premiums

One of the most difficult and controversial areas of business valuation is the determination and application of discounts and premiums. In addition to the difficulty in determining and applying them, they are difficult to explain. In order to make it easier to explain discounts and premiums, I developed a new chart based on a simple chart used by many appraisers. A copy of an article I wrote that was recently published in the Summer 2000 issue of Business Appraisal Practice, the professional journal of The Institute of Business Appraisers, Inc. is enclosed [shown below].

Different appraisal methods may yield a result with a different level of value than needed. A discount or premium may need to be applied to the value to convert it to the needed level of value. Two key factors must be addressed in determining the applicability of most discounts and premiums. These two factors are Control and Marketability. There is a big difference between being able to sell an entire privately held company or trying to sell a minority (lack of control) position in a privately held company. Quantifying this difference is not a simple matter. For example, a two-percent interest in a successful private company may not have much value to many people. Such an interest would be difficult to sell—thus a large minority discount may apply. However, suppose the only other shareholders are two individuals that each own 49% and do not get along. A two-percent interest in such a case may have tremendous value. Marketability, sometimes referred to "as if freely tradable," deals with the liquidity of a business interest or the amount of time required to convert the interest to cash. An investment in a publicly traded security can usually be converted to cash in a few days. An investment in a privately held company often takes considerably longer to convert to cash.

Selection of appropriate appraisal methods and the correct application of discounts and/or premiums must be determined by a competent business appraiser and clearly explained in each and every case.
Discounts and Premiums: A Chart to Illustrate them More Clearly

Article written for Business Appraisal Practice, Professional Journal of The Institute of Business Appraisers, Inc.  
 (To be published in the next issue). Paul R. Hyde, EA, CBA, BVAL

The application of discounts and premiums in an appraisal report for a minority interest has long been the focus of criticism of our industry. A long, well written business appraisal report supporting the value selected before discounts is often hit with a discount of 35% to 60% near the end of the report with only a paragraph or two in explanation. This can lead to confusion, skepticism, and misunderstanding on the part of the reader.

Discounts and premiums is an area of our business replete with differences of opinion and controversy. For instance, whether or not a discount for lack of marketability should be applied to a control marketable (sometimes referred to as control as if freely marketable) interest is controversial.1 Other differences of opinion relate to what type of indicated value is derived from a specific appraisal method. The discounted future benefits method could generate a control or minority, marketable or non-marketable value depending on a variety of circumstances. Additionally, there are a variety of methods referred to by the name Merger and Acquisition Transaction Method: some result in control marketable values, others in control non-marketable values, or others still in non-marketable minority interest values. The appraiser must clearly define the term marketable or marketability as he or she is using it in a specific instance. The marketability of a subject business interest is relative, not absolute. In other words, marketability or the degree to which a specific business interest is "as if freely marketable" or "not freely marketable" needs to be clearly stated and supported in appraisal reports.

The selection of the discounts and premiums applied by the appraiser to various methods used, the size of each of them, and the stated type of value to which they are applied is often subjective. Also, depending on how the methods used are applied, the nature of the value obtained may be different in one appraisal than in another. The appraiser must support his or her position and explain it thoroughly and well.

The chart shown below illustrates the various types of indicated values typically generated by a number of common appraisal methods and the types of discounts and/or premiums applied to the indicated value to calculate the level of value needed. If you feel that an appraisal method belongs at a different level of value than shown, simply move it and explain why it belongs at that level of value in your description of the method. This chart is an adaptation of the well known "Levels of Value" chart developed by Chris Mercer.2 I find it helpful to show the levels of value, the directions and names of discounts and premiums together with the appraisal methods utilized on the same chart lined up with the appropriate level of value. Seeing each of these items together often helps the reader understand why the various discounts and premiums are needed.
Discounts and Premiums Chart
Clearly identifying how the various levels of value apply to the specifics of the business being appraised allows the reader to understand why discounts or a premium are applied to the indicated value derived from a specific appraisal method used in the report. The appraiser must still explain in detail the selection of the size of each discount or premium. However, by using a chart similar to the one referenced above, the "big picture" as to why the discounts or premiums are necessary is more easily understood.

_____________________________

1 Bishop, David M. "Lack of Marketability Discounts for Controlling Interests," Business Appraisal Practice, Spring 2000, p. 39.
2 Z. Christopher Mercer. Quantifying Marketability Discounts: Developing and Supporting Marketability Discounts in the Appraisal of Closely Held Business Interests. (Memphis, Tenn: Peabody Publishing, LP, 1997), p. 15.
3 Both the discounted future benefits method and the capitalization method are shown in this chart as yielding a control marketable value. The type of value resulting from these methods depends on how normalization adjustments were made and the derivation method used for the discount and/or capitalization rate. The appraiser must locate the methods used in the appropriate box for this chart to accurately represent the case being illustrated.
4 The term Merger and Acquisition Method may apply to either a public company or a privately held business. Thus the result from the method used may yield a different type of value than is shown in this chart. The appraiser must locate the method used in the appropriate box in order for this chart to accurately represent the case being illustrated.
5 Some appraisers use the Excess Earnings Method to value entire companies when combined with the Adjusted Book Value Method. Others feel that the method should only be used to value intangible assets. If the method is used, the appraiser must understand and explain its limitations.
6 The Control Premium label shown on the chart is illustrated by the arrow leading from the Marketable Minority Interest Value box to the to Control Marketable Value box.
7 The Discount for Lack of Control label shown on the chart is illustrated by the arrow leading from the Control Marketable Value box to the Marketable Minority Interest Value. 

November 15, 2000 - Review of Business Appraisal Reports

As has been discussed in previous articles, there are no licensing requirements for business appraisers. Accordingly, many people often end up doing a business valuation without much experience and training. Unfortunately, even a few individuals with a business valuations credential may not really be experienced and may do a poor job. How can you tell if the business valuation you are looking at is done properly? The best way is to have an experienced, trained business appraiser review it for you. I do many review appraisals. The following are a few of the things I look for:

1. Qualifications and professional experience of the appraiser. In the business appraisal field, the appraiser should have one or more of the following professional designations:

  • Certified Business Appraiser (CBA) issued by The Institute of Business Appraisers, Inc.
  • Accredited Senior Appraiser (ASA) issued by American Society of Appraisers
  • Accredited Business Valuator (ABV) issued by The Institute of Certified Public Accountants

Being a Certified Public Accountant (CPA), a business broker, a college professor, a stock broker, or some kind of business consultant by itself is not enough. Business valuation requires additional training and experience.

Did the appraiser review the economic and industry data and clearly explain how the data affects the business being appraised?

Did the appraiser discuss relevant criteria regarding the business appraised such as its history, prior transactions in the stock, any restrictions or agreements affecting the stock, products and services, sales and marketing, the customer base, competion, and future prospects for the company.

In the financial analysis of the company, did the appraiser explain how the company compares to the industry and to itself in the past? Did the appraiser adjust the financial statements to an economic basis and explain each of the adjustments? Did the adjustments make sense?

Did the appraiser prepare a financial forecast for the business? Did the appraiser explain the assumptions used? Does the forecast make sense? Is it realistic or "pie in the sky?"

Did the appraiser discuss all three basic approaches (asset, market, and income) and the methods typically employed in each approach?

In the application of the appraisal methods employed by the appraiser, were the various steps and assumptions made explained?

Did the appraiser explain how the discount rate and/or capitalization rate was calcualted? Does the explanation make sense?

Did the appraiser apply discounts and/or premiums? If so, were they clearly explained and justified?

In the final reconciliation of value, did the appraiser explain how and why each method employed was weighted in obtaining the final value.

Last, but perhaps most importantly, did the appraiser show how the final value was evaluated to show that it is reasonable?

Business appraisals are complex and include parts that are highly subjective. An experienced and highly trained business appraiser should explain what has been done in a way that can be understood by a non-expert. A good business appraiser should be qualified to go into court and explain to a judge or jury in a way that they can understand, just what was done and why it is correct.

The following is a list of other common problems I have found in many business appraisals:

  • "Numbers only" appraisals done by some computer program; "garbage in, garbage out"

  • Rule of thumb valuations – incomplete, wide unexplained variations in the value

  • Unclear definition of what is actually being appraised – stock vs. asset problems

  • Inappropriate standard of value used – fair market value vs. investment value vs. fair value

  • Problems with assumptions underlying projections – "sales to the world" issues

  • Using inappropriate appraisal methods or using methods incorrectly
October 16, 2000 - FLP/LLC Valuation Discounts Redux: Know When to Hold ‘Em, and When to Fold ‘Em

IRS guidelines on "acceptable" valuation discounts for family limited partnerships and limited liability companies are generating apprehension among tax practitioners and their clients. I beg to differ: in fact, I am more confident than ever that my "aggressive" discounts will stand up to the fiercest audit scrutiny. Here’s why:

My understanding is that the IRS has set maximum discounts of 15% for lack of control and 25% for lack of marketability. Above those limits, audits are threatened as being highly likely.

Most of the FLP/LLC entities I see own marketable securities and/or income-producing real estate. These entities resemble closed-end investment companies, which typically trade at discounts from net asset value of 5 to 15%. Closed-end discounts are a strong proxy for the discount for lack of control for these entities. Other studies indicate much higher discounts for lack of control—most of these studies apply to operating companies. Some appraisers do NOT believe that operating company discounts – which are far larger than closed-end discounts– apply to holding entities. Each case must be considered and evaluated on its own merits by a competent business appraiser.

The 25% lack of marketability limit, however, clearly flies in the face of marketplace realities. Studies of restricted stock sales and pre-IPO transactions, both reasonable proxies for the discount for lack of marketability, have consistently found discounts far higher than 25% - more on the order of 45%. The Service can muster no empirical data to support its arbitrary 25% line in the sand.

Additional studies of resale prices of publicly traded real estate limited partnership interests – which measure the combined discount for both lack of control and lack of marketability - consistently corroborate discounts above 40% for partnerships which do not distribute income. The issue of whether or not an entity is required to distribute income is the single most important variable influencing the size of the valuation discount.

This last point is particularly interesting. If one uses the standard information, the discounts so developed will considerably exceed the Service’s guidelines and will be reinforced by additional independent, objective data. Those that are documented properly WILL STAND ON THEIR MERITS. In cases where there is objective, plentiful valid market evidence from a variety of sources and multiple logical methodologies to analyze it, I am aggressive because I can defend my discount conclusions.

Some additional points on special discounts:

When planning charitable donations of limited or non-managing membership interests, we recommend granting a put option to the donee. If the donor has sufficient liquid assets to honor the put, the discount for lack of marketability will be eliminated, substantially increasing the value of the donation.

Some clients are forming "master" FLP/LLC entities to own limited or non-managing interests in other such entities. From a valuation perspective, these master entities create another tier of discounts for lack of control and lack of marketability. This is because two entities, not just one, must be pierced to access the underlying assets.

Sometimes clients are reluctant to claim "aggressive" discounts because they fear IRS scrutiny. In such cases, we can append fairness opinions (at no extra cost) to our valuation discount analyses. Such an opinion states in essence that "You have asked us to opine as to the fairness of a combined (for example) 30% discount on the subject entity. The attached analysis indicates that a 45% discount is indicated based on entity characteristics and market data. Accordingly, the 30% discount is fair, reasonable and conservative."

The bottom line is that each case must be considered carefully by a competent business appraiser and discounts assigned that make sense and that can be supported.

September 18, 2000 - Buy-Sell Agreement Problems (A 1/3 may not be a 1/3!)

One of the biggest problem areas in buy-sell agreements is the valuation provision. Federal gift and estate tax rules require the use of "fair market value" as the standard of value to be used. Many attorneys use "fair market value" as part of the definition in a buy-sell or stock redemption valuation clause. This can be a serious problem in cases such as with three equal "partners." Three equal owners may want to specify that upon the trigger event, that the departing owner receive a prorata one-third interest of the entire business. The standard of fair market value requires a business appraiser to apply a minority discount (often called a discount for lack of control). Minority discounts vary widely but discounts of approximately 25% are very common. Let’s assume that a company owned one-third each by three individuals is worth $300,000. The value for a one-third owner is shown below under two different standards of value:

Fair Market Value:

Total Value-Equity $300,000
Less: Minority Discount 25% or $75,000
Total Value – After Discount $225,000

Value of One-Third Interest $75,000

Fair Value (Pro-Rata Basis):

Total Value - Equity $300,000
Divided by 3

Value of One-Third Interest $100,000

As you can see, the standard of value chosen can make a huge difference in the actual value of a minority interest in a company. Other problems arise by using book value or some other standard—often resulting in a different value than that intended. Buy-sell agreements should specify not only the mechanism for pricing the business; they should also deal with the terms of payment. Remaining owners must be able to make the payments or obvious problems arise.

Business appraisers are often asked to advise a company and its attorney of the implications of the valuation provision wording, including what valuation methodology might be used or rejected and the effect the wording might have for valuations for other purposes such as gift and estate taxes.

August 14, 2000 - Appraising Appraisal Designations

Professional designations are the most important factors to consider in selecting a business appraiser. Appraisers who have earned top-quality designations through testing and rigorous peer review have decisively established their competence.

Four professional societies currently offer designations:

The Institute of Business Appraisers, Inc.: IBA’s senior designation is the CBA (Certified Business Appraiser) which requires that applicants pass a tough examination and submit two actual appraisal reports for peer review. IBA generally focuses on the valuation of small to medium-sized businesses.

The American Society of Appraisers: ASA’s senior designation is the ASA (Accredited Senior Appraiser) which requires that applicants have five years of full-time equivalent appraisal experience and that they pass a tough examination and submit two actual appraisal reports for peer review. ASA generally focuses on the valuation of larger businesses.

The American Institute of Certified Public Accountants: AICPA members who are CPA’s can qualify for the ABV (Accredited in Business Valuation) designation by passing an examination.

The National Association of Certified Valuation Analysts: NACVA members can qualify for the CVA (Certified Valuation Analyst) designation by passing an examination and writing up an appraisal case report.

We believe that the first two designations listed above are the most meaningful based on the stringency of the peer review of actual appraisal reports. The last two are not quite as difficult to obtain. I have the first designation listed and I am in process of receiving the second.

July 17, 2000 - Court Cases Court Trouble for Appraisers

Some business appraisers misuse court cases in many ways:

  • Appraisers are not attorneys. We should not use data (verdicts) that we are unqualified to interpret.
  • Court cases are not probative for appraisers: they reflect the opinion of triers of fact, not marketplace conditions.
  • Market data is probative: it reflects the real world. We are charged with reflecting the real world.
  • Lower court verdicts are much less significant than higher court decisions.
  • Some case law is flat-out bad. An example: for many years, discounts for embedded capital gains taxes (on highly appreciated assets) were not allowed. This flew in the face of marketplace realities. Recent court decisions rectified this glaring deficiency.

Appraisers should consider court cases as being technically instructive when the written opinion discusses which side was most persuasive and why, what errors were made, etc. Blind reliance on summaries of court decisions (i.e. "the average discount allowed in similar court cases was X%") is inappropriate.

Remember that:
  • Appraisers are charged with coming up with independent opinions, not regurgitating precedent.
  • Appraisers should never cite case law precedents or summaries. We are not attorneys!
  • Appraisers should not fear being aggressive when they have the facts. An example: our discounts for lack of control and lack of marketability are almost uniformly greater than IRS guidelines. We will defend our conclusions to the death based on ample, strong market data, rigorous analyses, multiple calculation methods and crosschecks of conclusions.
June 19, 2000 - How to Value Very Small Businesses

Some of our engagements involve very small businesses such as single location retailers or franchises. Their characteristics and markets are unique, and they are valued differently than larger firms.

The key point: buyers’ acquisition motivations often depend on how large the business is. For very large businesses, buyers analyze return on investment: profit or cash flow relative to acquisition cost. Mergers are priced on this basis. Most people invest in the stock market this way. As the business gets smaller, return on investment becomes less important than simple profit or cash flow. For very small businesses, the buyer’s motivation is often just to buy a job and earn a reasonable salary: profit is not an objective. Only at the end of their careers do small business owners think about "cashing out" at high prices. Their expectations are often unrealistic because they have never run their businesses to generate, let alone maximize, profit or return on investment.

As business brokers, we often sell businesses of this or similar size. These very small businesses typically sell between one and two times what we call Owner’s Discretionary Cash Flow. We define owner’s discretionary cash flow as the amount available to the owner from the business in a year—we add back owner’s salaries, interest expense, depreciation, and all owner’s perquisites including all the toys they charge to the business.

These businesses are tricky to appraise. Often, the financial information available is incomplete or of poor quality. The determination of "reasonable compensation" is subjective: what may be reasonable to one person is certainly not to another. We use a level of "reasonable compensation" determined by our experience with business buyers and what is available from industry data.

Unless the business is losing money or marginally profitable, an asset approach is rarely used in valuing a very small business. Instead, the following methods are often used:


Capitalization of income (Net of "reasonable compensation")
Market comparables
Rules of thumb
Justification of purchase tests

The capitalization of income requires the appraiser to determine a rate of return that would be required by a buyer as well as a level of reasonable compensation. In very small businesses the rate of return is often 33% to 70%.

Market comparables can be persuasive, but there is often little reliable data available. Rules of thumb are highly anecdotal, and are often vague as to what assets and liabilities are included in formula prices. However, they are helpful in establishing a range of values.

The justification of purchase test is the best valuation method for very small businesses because it is case-specific. This test determines whether:

The buyer can earn an acceptable level of compensation (salary plus benefits)
The buyer can prudently repay acquisition-related debt (both principal and interest)

The test involves projecting the financial results of the business for several years with appropriate compensation and debt service assumptions. If the business has positive cash flow, the purchase price is justified. There is no consideration of return on investment (cash flow relative to purchase price) because that is inconsistent with the buyer’s motivation. This is essentially what we do for every sale of a very small business. The buyer has to be able to make a living and pay for the business after making a reasonable down payment.
May 15, 2000 - Article on Skimming Sellers

An article that I wrote entitled "Dealing with ‘Skimming’ Sellers" was recently published in the professional journal for the International Business Brokers Association, Inc.; the IBBA News. I have enclosed a copy for your review. Sellers that do not report all of their income is a common problem in the business brokerage and business appraisal industry. I hope this article will be of interest to you.

I would also like to take this opportunity to invite you to look at our web page. It can be found at www.hydebpv.com. Along with information about our company and the list of businesses we currently have listed for sale, we have a lot of information on business appraisals including the following:

  • Selecting a Business Appraiser
  • Reasons to Get a Business Appraisal
  • The Valuation Process
  • Types of Valuations and Reports
  • Litigation Support
  • Seminars
  • Frequently Asked Questions
  • Revenue Ruling 59-60 ("the Bible")

Our Helpful Sites page lists many sites of interest dealing with buying or selling a business, economic information, financial information, government agencies, estate planning information sites, tax related information sites, and legal related information sites.

I hope you will find our web site useful. If you have any suggestions for improvements or other comments, we look forward to hearing from you.
April 17, 2000 - Who Wants To Be an IPO Millionaire?

Media and cocktail party chatter increasingly glorifies IPOs (Initial Public Offerings) as the Holy Grail for business owners. We have a contrary view: their risks outweigh their returns. To see why, let’s play "Who Wants To Be an IPO Millionaire (MillIPOnaire?)"

For $500 (THIS game is for serious money): What costs more than an IPO?
Babe Ruth’s Rookie Card
The Hope Diamond
The Empire State Building
A Small Nation…You’ve got $500!

For $1,000: After their IPOs, business owners will concentrate on:
Marketing
People
Profits
Daily stock price fluctuations…You’re right!

For $2,000: If a public company misses a quarterly Street earnings estimate or has a "surprise":
Big deal, we are all long-term investors, who cares?
The stock drops, shrewd investors buy it on weakness and it rebounds
Wall Street downgrades the stock
The stock drops over 30% in one day (even if it is Procter & Gamble)…Right!

For $5,000: The seller will now deal with a fascinating group of new friends:

Customers
Suppliers
Employees
Wall Street Analysts…You got it!

By the way, there are no safe harbors in THIS game. For $10,000: Which stocks do Street analysts hate to cover?

Takeover candidates
General Motors
Dotcom startups
Your IPO trading 10,000 shares a month…That’s good for $10,000!

For $15,000: What’s the most important thing for a post-IPO manager to work on?
Developing people
New products, innovations and technology
Strategy
SEC compliance…Right!

For $25,000: Their time horizon will be:
Retirement
Decades
Next Year
Next Quarter’s Earnings…You got it!

For $50,000: They:

Are prepared for this radical change in "workstyle"
Will just love dealing with the financial community
Understand how critical it is that they promote their companies to investors
Have no idea how draining and time-consuming all of this will be…Yup!

For $100,000: A company must be how large in sales to keep Wall Street interested:
$25,000
$50,000
$75,000
$100,000…You just won $100,000!

For $250,000: Underwriters look at the following when considering IPO candidates:
Sales
Earnings
Cash Flow
Assets

Want to use a lifeline? 50-50? OK:
Sales
Earnings
Cash Flow
Assets

Another lifeline? Call a friend? Fine. "Hello, Mr. Buffett, this is Paul Hyde on "Who Wants To Be an IPO Millionaire?" Your friend needs your help. Which of the following do underwriters look at when considering IPO candidates: earnings or sales?"

Buffett: "Well, it used to be earnings, but as I wrote this year’s letter to Berkshire Hathaway shareholders, last year was my worst ever, a real annus horribilis, and I always pick stocks based on trivial Old Economy details like earnings. So I’d have to say Sales."


Sales…You just won $250,000!

For $500,000: Which provides the most liquidity?


A sale to an ESOP
 An IPO
 A sale to a public acquirer for stock
 A sale to a public acquirer for cash

Let’s see, Paul, an ESOP sale has to be at fair market value, which rules out inflated public company multiples, so that can’t be right. IPOs are expensive, with legal, auditing, underwriting, road show and promotional fees, not to mention ongoing regulatory compliance costs. IPOs do not provide immediate, full liquidity. In fact, sellers are locked in more than ever! Sure, they can sell a few shares in a secondary offering, but not so many as to raise investors’ suspicions. They are heavily constrained by insider trading and Rule 144 restrictions. So nix the IPO. A stock deal defers taxes, but the seller is locked in by the very same restrictions so they have limited liquidity. I’ll say:

A sale to a public acquirer for cash…Is that your final answer?…Yes!…You’ve won $500,000!

Don’t get nervous, but here comes the big one: for $1,000,000, are you going to IPO your company?
In a New York Minute
Greed Is Good
Show Me The Money
Not
March 13, 2000 - The Toughest Part of Business Appraising: The Multiple

A business is generally valued at a multiple of earnings (or cash flow). Determining the multiple is usually the biggest challenge in an appraisal assignment.

Valuation multiples are set by the market, and reflect expected levels of interest rates, inflation and risk. Expectations cannot be measured in real time, so they must be estimated. There are many theoretically sound ways to do this, but they are highly uncertain. Skill, analysis and judgment are required to be sure that these estimates are logical and reasonable.

Most appraisals, ours included, provide extensive details and elaborate methodologies to determine multiples. They are based on expected rates of return and risk as measured by the financial markets. (Multiples are the reciprocals of capitalization rates. A multiple of 5.0 implies a capitalization rate of 1 / 5 = 20%.) 

One way of estimating multiples is to look at market evidence to set a floor and a ceiling. On the high side, venture capitalists generally require a minimum before-tax rate of return of 40% to fund startups, the riskiest of all businesses. This implies a minimum multiple of 1 / 40% = 2.5 times. On the low side, studies have shown that a diversified portfolio of "small-cap stocks" (publicly traded stocks with market values in excess of $150 million) has consistently returned 20% annually, implying a multiple of 1 / 20% = 5.0. This confirms the anecdotal range of multiples of 3 to 5 times operating income for the typical small to medium size privately held business. There are, of course, exceptions that fall outside this range.

Our take on the AOL-Time Warner merger: The geek shall inherit the earth.

The typical business, however, is worth much less than $150 million and is far riskier, because it is not diversified and depends on a few critical people, products and markets. Logically, its expected rate of return should be above 20% and below 40%.

This is where an appraiser’s skills are required. Careful analysis of relevant economic and industry factors, coupled with a close look at the company’s operations and finances, allows us to make informed judgments about the company’s growth potential, future profitability and risk (defined as the volatility of its earnings and the chance that it might go bankrupt). These form the basis for estimating how far above 20% and below 40% the company’s capitalization rate should be.

Most competent business appraisers are comfortable distinguishing between three risk levels: low, moderate and high. These correspond to capitalization rates of 25%, 30% and 35%, and multiples of 2.9, 3.3 and 4.0, all in round numbers. Further precision is just not possible. Competent appraisers whose capitalization rate estimates are within 5% of each other’s will almost always compromise. If they differ by more, they should be able to clearly articulate why they differ (in terms of the risk factors described in the preceding paragraph).

When reviewing an appraisal, ask yourself four questions:


Does the multiple estimate refer to the economic, industry and company analysis?

Is it consistent with those findings?

Does the multiple estimate refer to market data?

Is it consistent with that information?

If the answer to all four questions is yes, the estimated multiple is probably reasonable.

February 14, 2000 - Price Negotiations: Ready, Fire, Aim!

In my previous life as a commercial banker, I was often frustrated by the organizational tendency to constantly reconsider and fine-tune action proposals. This is called the "ready, aim, ready, aim..." mentality. Nothing ever seemed to get started! I much prefer the more entrepreneurial mentality of "ready, FIRE, aim." Come up with an idea, pilot it, get feedback, refine it and execute!

This motto particularly applies to price negotiations. Conventional wisdom is that the first person to mention price loses. This is certainly true when there is a big difference in knowledge between buyer and seller. If we own a piece of land and someone else finds oil under it (but we do not know this), the buyer would be crazy to raise our suspicion with a high offer. A shrewd buyer bases their offer on what (they think) the seller does not know. 

In most business acquisitions, smart buyers do the appropriate due diligence to level the information playing field. They get information before making offers and protect themselves with escape clauses and contingencies. Sellers are (hopefully) knowledgeable of what they own and have the benefit of competent advice. In this type of case, both sides have much the same information and can fairly negotiate unless there are unique circumstances (such as a seller who just can’t pull the trigger or a buyer who balks at commitment). If both parties are honest, competent, willing to compromise and to share risks, there is always a way to structure a deal. As business brokers, we participate in this type of transaction almost daily. 

In these situations, the shortest distance from initial offer to agreement is for one party to make an offer and disclose its basis. Where is the risk if both sides are relatively well informed?


It is the basis, not the price, which has to be appropriate for the other party. A business seller stating that they want $2 million so they can invest the after-tax proceeds at no risk and earn a sufficient income to retire has not made the case in the buyer’s terms. Why is such a deal good for the buyer? A much more compelling statement would be "If you invest $2 million to buy this business, we can show you how to earn 30% a year!" Now you have our attention, seller!

Where is the risk in this strategy? The party who is ready to fire seizes the initiative with a proposal couched in the other’s language, which makes it easy to understand. They will react more easily with a counter, providing feedback, and the parties are on their way to a deal, not endlessly fencing. 

January 11, 2000 - Who Values Businesses?

Those who value businesses today include business appraisers, accountants (CPAs), business brokers, college professors, and commercial real estate appraisers. Each of these groups of professionals brings something unique to the practice and each has advantages and disadvantages.

Professional business appraisers are typically well trained and generally have credentials from a professional appraisal association. Many of these individuals work with large businesses using public stock market data and may have difficulty valuing a small hardware store--not Home Depot!

The number of accountants (CPAs) doing business appraisals has been increasing in recent years. Accountants are very familiar with financial statements but many are uncomfortable making forecasts--a necessary step in business valuation. Another problem is potential conflicts of interest. For instance, preparing tax returns for a business and then adjusting the level of officer's compensation in an appraisal for being excessive.

Business brokers have a distinct advantage over others as business appraisers as they are involved in actual transactions in the market. However, many business brokers do not have extensive financial or appraisal training. They tend to rely too heavily on various rules of thumb.

College professors often have great academic backgrounds for business appraisals but they often try to apply very complex formulas to small closely held businesses. They also have difficulty explaining what they have done in language a jury can understand.

Commercial real estate appraisers are very familiar with appraisal methodology, but many are less familiar with the accounting concepts of financial reporting. Also, they often have difficulty understanding the need for much higher discount rates in valuing a business than for valuing a commercial real estate property.

I fit into three of the above five groups. First, I am a Certified Business Appraiser and have been trained to do professional business appraisals. Second, while not a CPA, I am Enrolled to Practice Before the IRS, often referred to as an Enrolled Agent. This means that I am licensed to represent people at any level of audit within the Internal Revenue Service. Third, I am a business broker. I sell a wide variety of businesses giving me direct market experience in addition to academic qualifications and professional credentials.

There are a number of Professional Appraisal Organizations. The following are the most common:

The Institute of Business Appraisers, Inc. (IBA)

The American Society of Appraisers (ASA)

The National Association of Certified Valuation Analysts (NACVA)

The American Institute of Certified Public Accountants (AICPA)

 The Institute of Business Appraisers, Inc. (IBA) was formed in 1978. In order to receive its designation of Certified Business Appraiser (CBA), a candidate must pass a comprehensive written exam and have two appraisal reports reviewed and approved by a Qualifications Review Committee. There are approximately 300 CBAs nationwide.

The American Society of Appraisers (ASA) formed a business valuation group in 1981. It issues credentials to applicants after they pass a test and submit two appraisal reports for review. It issues a credential called Accredited Member (AM) for those having less than five years full time experience or Accredited Senior Appraiser (ASA) designation for those with five or more years full time experience. There are approximately 2,000 individual business valuation members.

In 1991, the National Association of Certified Valuation Analysts (NACVA) was formed. It requires members to be a CPA, take a five day training workshop and pass a take-home examination including a case study and report writing requirement before receiving a Certified Valuation Analyst (CVA) designation. There are approximately 2,600 members and approximately 2,100 CVAs.

The American Institute of Certified Public Accountants established a designation called Accredited in Business Valuation (ABV) in 1997. Requirements for the designation include being a licensed CPA, passing a written examination, and providing evidence of ten business valuation engagements that demonstrate substantial experience and competence. 

I have been awarded the Certified Business Appraiser (CBA) designation by the Institute of Business Appraisers and am a member of the American Society of Appraisers. A copy of my professional qualifications is enclosed with this letter.

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