"Figures don't lie" is the old adage, but is it really true? I had an uncle who used to tell me "For the past 20 years my business has lost money every year." When I said, "Uncle, how can you stay in business and sustain those losses?" He replied, "I make it up on volume."
The facts are these: If you want to show that your business is a loser, it is not too difficult to do. Conversely, if you want to show that your business is a winner, it's also not too difficult to do. Sooner or later, however, there will come a time of reckoning. If you constantly show losses in order to keep your taxes low, what happens when you want to sell the business or borrow against it? If you constantly show high profits because you are not paying the typical operating expenses that your business should pay, then that could create another problem.
In past years banks that are Small Business Administration lenders did not require an appraisal of the business they were lending on. They are now required to have an appraisal in their file. The problem, however, is that there is little oversight by the Feds on the loans made by these banks when it comes to valuation standards. The appraisers selected are not required to perform to any level of professional performance.
Let's look at a case in point. Smith is the sole shareholder in a small manufacturing company and needs a bank loan. He applies to an SBA lender bank and is asked to submit his corporate financial reports and tax returns for the past year. They indicate that his business profit is marginal and the loan is rejected. Smith objects on the grounds that the business is a money maker.
Scenario No. 1: The bank, or borrower's, appraiser did not comply with accepted professional performance standards. He failed to consider that:
* The real estate where the business is situated is personally owned by Smith and the business pays double the fair market rent.
* Smith's son, who is away at college, is on the payroll. He does not contribute to the business, but is paid a five-figure salary.
* Smith's wife heads up the accounting department and is paid twice what her replacement would cost.
* Smith is paid a salary that considerably exceeds fair and reasonable compensation.
* The reports and returns are based on cash reporting. They do not consider sales based on credit, therefore the reports and returns do not include accounts receivable (substantial) or accounts payable (minimal).
* The business pays Smith's auto payments, personal insurances, medical expenses, and a lot of other perquisites.
Based on the bottom line of the business, and without adjustments,
Smith's business operates on an 8 percent rate of return on invested capital. Research indicates that, based on risk, the accepted rate of return for this business should be in the range of 18-20 percent. The bank considers Smith's loan request to be very high risk. The estimated range of value for this business is $600,000 to $700,000.
Scenario No. 2: The bank has selected a business appraiser who performs at a high level of standards and looks at this business through a totally different pair of spectacles. He makes adjustments, as follows:
* Although Smith still owns the real estate, rent is adjusted to fair-market rent, what any tenant would be expected to pay.
* Smith's son, who does not contribute work, is removed as a salaried employee.
* Smith's wife, who heads up the accounting department. has her salary adjusted to fair-market compensation, what it would cost to replace her.
* Smith's salary is adjusted to fair and reasonable compensation based on his job description and on compensation studies.
* The financial reports are adjusted to reflect accrual reporting. Annual sales were actually $700,000 more than reported on a cash basis. Accounts payable were about $50,000 more than on a cash basis.
* Smith's perquisites are adjusted to remove personal expenses charged to the business.
After these adjustments it appears that Smith's net profit really represents an approximate 20 percent rate of return on invested capital. The business could have a range of value of $1,400,000 to $1,600,000; a lot different from $600,000 to $700,000.
So, what is the message? Did the figures lie? Well, yes and no! Again, it all depends on what it is that the owner is trying to show.
Jerry F. Golanty of Reno is a Master Certified Business Appraiser and Business Valuator Accredited in Litigation. He serves as governor of the Institute of Business Appraisers for Nevada, California, Arizona, Utah, Hawaii and the Far East-Hong Kong. Contact him at BizVal, 775-332-4881.
