How a business appraiser does the job

I've often been asked, "What does a businesccs appraiser look for when valuing a business?" The typical appraiser attempts to establish whether the business is profitable, healthy, and has a future. Taking them in that order, most appraisers will try to establish whether the business has discretionary earnings, EBITDA ( earnings before interest, taxes, depreciation, amortization), and net worth, (assets in significant excess over liabilities). However before the appraiser starts, there are several things that must be first determined by the client.

They include:

Identify the purpose for the appraisal such as establishment of the value of 100 percent of the enterprise of establishment of the value of a fractional interest, etc.

Identify the function of the appraisal such as whether it is for internal planning or for litigation.

Identify the effective date of valuation (a specific date). Note: An appraiser cannot hit a moving target.

Identify the standard of value. Is it fair market value, fair value, investment value, liquidation value or some other standard

Discretionary earnings are all the benefits adhering to an owner, whether in the form of salary, perquisites or other benefits. Perquisites might include insufficient or excessive rent when the landlord and business ownership is not at arm's length, personal insurances, personal auto expenses and personal home expenses. Discretionary earnings are calculated before owner's compensation. EBITDA is similar to discretionary earnings except it is calculated after owner's compensation. Net worth is a balance -sheet exercise that calculates assets and liabilities. The greater that assets exceed liabilities, the greater the net worth.

Financial documents and reports must be adjusted or recast by the appraiser. They are typically tax-oriented documents designed to show revenue at its lowest, expenses at their highest and profits at their lowest in order to minimize taxes. The appraiser will typically recast the financial documents to convert them from historic, tax-oriented documents to economic, profit-oriented documents. It is no secret that tax oriented financial documents are preferred at tax-time. However it is a totally different matter when it comes time to sell the business and a value is placed on profits and earnings.

After determining discretionary earnings and EBITDA, the appraiser typically conducts research to determine, among other things, factors that impact on a subject business, such as industry forecasts, economic forecasts, completed transaction studies and owner's compensation studies. Most of this data is categorized by an SIC (Standard Industrial Classification) or NAICS (North American Industrial Classification System)number. The appraiser must therefore identify the appropriate SIC or NAICS number. The numbers and categories have been established by the federal government.

Capitalization and multiplier rates must be developed. A capitalization rate is the rate of return that an investor requires. The rate of return is market-driven and takes into consideration the risks inherent in the business, such as liquidity and marketability. The greater the risk, the higher the required rate of return. A capitalization rate is the reciprocal of a multiplier rate. An investor who expects an investment to be returned in four years must receive a 25 percent annual return on the investment. Capitalization and multiplier rates are applied to discretionary earnings and EBITDA to arrive at the values achieved by those methods. Net worth is then added to arrive at the total enterprise value. If the interest being valued is a minority interest (50 percent or less), then discounts for lack of control and marketability must be considered.

After arriving at the value by each approach and method, the appraiser should weigh the various values and rank them in order of their relevance. For example, a business that is heavy on earnings would probably receive a heavier weight than a business that is heavy on fixed assets. The appraiser may settle on a single number or a range of value.

The appraisal should also meet the Daubert Criteria, established by the U.S. Supreme Court in 1999. The criteria asks, in essence, whether the approaches and methods used by the appraiser met the following criteria:

"1. Can the theories or techniques (methods) be tested or have they been tested?;

2. Have the theories (methods) been subjected to peer review or publication?;

3. What is the known or potential rate of error?;

4. Are there established standards to control use of the techniques (methods)?;

5. Are the techniques (methods) generally accepted in the technical community?"

If the approaches and methods have met the criteria, then the appraiser should proceed with testing the valuation by asking: "If the business was sold today at the appraised valued, and on terms prevalent in the market place, would the revenue pay for the cost of goods, all of the operating expenses, the debt service, a reasonable owner's compensation, and still leave over a reasonable return on, and of, the investment?"

If the answer is yes, then the valuation is validated. If the answer is no, then it's back to the drawing board.

From there the appraiser must, in most cases, issue a report, of which there are a number of types, but that is a subject for another time.

Jerry F. Golanty is president of BizVal in Reno. He is a Master Certified Business Appraiser and a Certified Financial Forensic Analyst specializing in business valuation litigation. Contact him at jerrygolanty@bizval.net or 775-332-4881.