There have been many times when I've heard "How much to value my business? I can have my house appraised for a fraction of that amount.". When it comes to appraising, valuing a house and valuing a business are not in the same arena. To the real estate appraiser, the most important issues, and not necessarily in this order, are:
1. Location.
2. Condition.
3. Features.
4. Comps.
5. Reason for appraisal.
Location: The old adage in real estate is that the three most important things are location, location and location. It's better to have the worst property in the best location than the best property in the worst location.
Location may be important to a retail business that relies on pedestrian or vehicular traffic and visibility; or a profession where the customer comes to the professional (doctor, lawyer, dentist, etc.). But, how important is location to a manufacturing company, a wholesale company, a service company, unless it needs freeway access, etc?.
Condition: While real estate needs to be in reasonably good physical condition (roof, plumbing, electrical systems, heating, free of mold/termites, etc.), businesses need to be in reasonably good financial condition (profitable, reasonably good ratio of assets to liabilities, etc.).
Features: In today's market a one- or two-bedroom home with one bath does not have the same marketability as a three-bedroom, two-bath home. Buyers and owners in today's market require up-to-date bathrooms and kitchens, heating systems, plumbing, etc. To a business this does not have a great impact. Most business real estate is leased. If a premises is obsolete. it becomes a landlord's problem since the tenant can always move. At this time there's an abundance of vacant business property that's available for lease and landlords are making huge concessions to attract tenants.
Comps (comparable sales transactions):
Real estate appraisers and agents rely on:
1. Multiple Listing Service records.
2. County recorder's records for transaction information.
The information can include features and descriptions of the property, selling price, terms of sale, recorded deeds, deeds of trust, etc. Real estate does not sell, nor is it appraised by component parts (rooms, roof, basement, heating systems, plumbing systems, etc.)
In the case of a business, there is nothing that would give a clue as to what a business sold for, the terms of sale, or what was included in the sale because here is nothing of public record. The definition of real estate is "the ground and everything attached to it."
When it comes down to it, there is no way to describe a business by the way it looks, etc. In fact, it really is a lot of component parts which, when put together, comprise a business: sales, expenses, discretionary earnings, EBITDA (earnings before interest, taxes, depreciation, amortization), machinery or equipment, inventory, assets, liabilities and net worth.
In the case of a business, comps are available to the appraiser on a subscription basis from organizations such as the Institute of Business Appraisers Data Bank (about 35,000 transactions), BizComps (about 10,000 transactions) or Pratt's Stats (about 7,000 transactions).
The data has been reported to those organizations by business brokerages, accounting firms, banks, merger and acquisition brokerages, etc. and the data are from all parts of the country. The data are also from various size companies and from recent to distant transactions. Empirical studies indicate that location, time, size, etc. have little, to no, impact on ratios of selling price to gross revenue and discretionary earnings.
Reasons for appraisal: The most common reasons for a real estate appraisal are:
1. Sale.
2. Loan.
3. Insurance.
The most common reasons for a business appraisal are:
1. Litigation (divorce, partner and shareholder disputes, landlord-tenant disputes, buyer-seller-agent disputes).
2. Taxes-related issues (estate taxes, eminent domain, gifting, donations).
3. Business planning (succession, expansion, new partners or shareholders, taking out an existing partner or shareholder, borrowing).
The basic approaches in valuing real estate are a cost approach, an income approach, and a market approach. And those same approaches are used in valuing businesses, but from there the similarities are as divergent as apes from humans.
In real estate, a cost-approach methodattempts to estimate what it would cost to reproduce the property, especially in the case of destruction. In a business the primary goal is to recast the balance sheet to represent current values (inventory, machinery/equipment, collectable accounts receivable, etc.) and to develop an adjusted net worth.
So what does the business appraiser look for?
1. The economy nationally, regionally, locally.
2. The industry and where it's heading. Is it a "pet rocks" business?
3. The financials: analysis, profitability, net worth.
4. Competition.
5. Suppliers.
6. Management.
7. The market and what similar business have sold for.
8. Owner's compensation.
9. A myriad of other things.
The primary objective in owning a business is to make money. If it makes money, it has value. If it does not make money, its value is questionable.
Jerry F. Golanty is president of BizVal, a Reno based business valuation and consulting firm. Contact him through www.bizval.net.
