A Business Valuation is Not Just In the Numbers

As a professional business appraiser, we are called to provide our best estimate of fair value. On its face, it would seem relatively straightforward to assume that most of it has to do with the financial well-being of the company, which it does. However, it is also very easy to overlook some of the more salient issues in the ongoing operations of a business which subtract meaningful dollars from its value. In our experience, the issues most prevalent impacting potential valuations can be found in the following areas: financial operations, sales function, operations, leadership and culture, as well as owner psychology. This article will outline a few of the key issues within these areas.

Financial

First and foremost, however, is the quality of the financials. It is critical for a business to have strong financial and internal controls. I have seen too many businesses fall flat on their face because they were still being operated much like they were when they first started out.

Operational infrastructure must evolve with the growth of the business, and the evolution of the financial function is one of, if not the most, critical components of a successful business. Not having a strong bookkeeping or accounting function is perhaps the most important reason why valuations fall short of expectations, and why sellers often feel unsatisfied after the transition or sale. In addition, poor financial management will often show itself in the financial statements and footnotes, which can reflect improper capitalization and/or cash flow management. Each of these on their face would receive due scrutiny from a qualified appraiser in their analysis.

A good bookkeeper or CPA can help you set up a clear, concise chart of accounts and establish strong internal controls for the handling, measurement and access to funds. Easy to follow, consistently applied procedures following generally accepted accounting principles is essential for an appraiser to gain an accurate assessment of the financial well-being of a business. A business lacking in this critical area could face meaningful haircuts to value in an appraisal.

Budgeting and financial forecasting are two other key pieces of the financial function which are commonly overlooked by business owners. Surprising to some, but most small business owners do not establish thoughtful and useful budgets. These are the roadmaps used by effective managers in carrying out the annual action plan which typically forms the basis of a strategic plan, which most business owners generally do not take the time to do.

Multi-year forecasts are indeed useful for qualified appraisers who can incorporate these forecasts into their assessment, even if the weights assigned to these projections are less than the ones assigned to the historical data they can see. Suffice it to say, a business appraiser will be able to paint a much more complete and holistic picture with this depth of information, which can also add meaningful value to a company. In other words, the more complete and insightful information available to an appraiser, the more value can likely be recognized.

Sales

Sales is the lifeblood of a business – the mother’s milk so to speak. It is certainly obvious, but you can’t have profits and value if you don’t have the throughput at the top of the financial statement. Of course, a business owner is focused on generating sales, but a good appraiser will want to more deeply understand the source and consistency of that revenue. An appraiser will also be concerned with whether the business has established leadership for the sales function, and whether that leadership has created and articulated a strategy surrounding revenue. Far too often, we see businesses that start as order takers from a few key clients, but never evolve their marketing, advertising and client relationship management functions in tandem with overall growth.

Many businesses are adversely impacted by high customer or client concentration. It is easy to assume these great relationships will persist into the future, but I’ve seen far too often where the law of the unknown takes over and the environment changes overnight. Often, the landscape can change due to the shift in the business or ownership of the client, a falling out over service or capabilities, or even as simple as a dispute over price. Large clients usually know when they have some leverage over the seller, and will try to use that to their advantage, especially when substitutes are available. It is admittedly hard to know when and if a substantial change in customer mix may occur, but it is a meaningful risk that any good appraiser will take into account when applying the approaches to value.

Operations

The income approach to value depends in substantial measure on the ability of a business to generate consistent profitability, especially for its industry group. Profitability comes from operating leverage; in other words, the ability to grow expenses at a rate less than sales. Underperforming businesses relative to their industry code cohort will usually get valuation markdowns from qualified appraisers doing their homework.

An appraiser will also look at the management of the operation itself. This includes not only the efficiency of the operations, but also the management of human capital. Often, we see business lacking in some of the most basic human resources functions, including compliance and required training. Sometimes, it is as simple as not even having a formal HR function at all. Businesses really are as strong as their weakest link when it comes to human resources, meaning that a shortfall in this area could lead to considerable financial impact and embarrassment for the business, as well as a potential valuation discount.

From an operational perspective, an appraiser will be interested in both the data and so-called soft items. These include an analysis of financial ratios, operating margins, as well as trends in the data. In addition, an appraisal should consider whether a company maintains proper oversight and management over facilities and equipment, purchasing, vendor management, suppliers, and even such things as intellectual property. We are surprised by the number of small businesses which fail to effectively plan for such things as equipment utilization, repair and replacement, not to mention effectively negotiate and maintain contracts with business partners and vendors.

Leadership & Culture

The culture of an enterprise may be hard to measure, but it is nevertheless very important to the worth and value of a business. Employee retention and turnover is one important variable that appraisers will want to understand, as well as some of the underlying drivers. Companies with weaker benefits and compensation programs will likely face more competitive employment pressures and increased turnover, which in turn creates increased discounts to value when analyzed by a qualified appraiser.

Another issue many businesses face is key person risk. We have enjoyed a strong economy over the last decade, which has led to strong new business formation and also to labor shortages in many markets. With tight labor comes increased competition for talent, especially experienced talent in key areas such as sales, operations or finance.

The risk of losing a key employee is certainly real, and can, with some effort, be quantified by a business appraiser in terms of its impact on business value. There are several good rhetorical questions which stem from this, not the least of which is the cost to hire and train replacements. Also, what is the revenue and operational disruption should they lose one or more of these so-called “key” employees...?

For example, a business may have an employee who represents a key sales relationship, sales channel or has skill in developing strategy. Some businesses have people who possess critical knowledge of the products or services or a proprietary process. The adverse financial impact to the business of the loss of this type of person can be significant, and a good appraiser will certainly take that into account during their assessment. The ability for a company to find ways to retain that key talent, through advanced compensation and retention programs, retirement plans and the like, can add meaningful value to a business in an appraisal.

Another aspect of key person risk is the exposure that a key person loss will have on the efficiency and productivity of the staff or leadership. As difficult as it is to assess culture, an experienced appraiser will be able to discern whether the loss of key employees will disrupt the team esprit de corps, or perhaps remove a key personality or psychological attribute from a high performing team.

Sometimes, the loss of a key employee might be a good thing, if that person was deemed influential but toxic to team balance or efficiency. A comprehensive appraisal should be able to look past the adjustment or transition period to account for the long-term gain in this case.

Owner Psychology and Readiness

Going beyond the application of control premiums and minority discounts, another important yet difficult-to-measure component of a qualified appraisal is the mindset of the ownership team. What are their goals, aspirations and motivations? If there is a single owner, how long have they been in the business? Are they happy, motivated, and satisfied? What would make them stay in the business longer (or leave earlier), and what does the future look like for them? If there are multiple owners, what is the relationship between the owners? Does the distribution of ownership adversely impact operations, satisfaction levels, or efficiency in any way? Also, what is the view of the ownership team of how they define “exit,” and what does that future look like for each of them?

A valuation performed as part of an effective exit planning process will certainly consider the existence and vitality of a succession plan. Most owners do not go through the exit planning process, however, and fail to create either a plan of succession or fail to cultivate and train the future leadership identified in the plan if it exists. Each of these issues on their own would lead to a discounted valuation by a qualified appraiser. In the case of family-owned businesses, oftentimes so-called “anointed” family members actually do not wish to carry on the legacy, leaving a void in succession which usually does not bear itself out until the eve of the transition or shortly thereafter.

A valuation performed as part of a transaction will want to assess why the owner(s) seeks to exit the business, sell or transition the business, as well as assess their view of the business legacy they are leaving behind. Sometimes, owners become frustrated by the tedious nature of running a growing business, especially if they were not effective in delegating or advancing the operating infrastructure noted above. Sometimes, it is due to business or personal divorce, where sale is the only possible solution to a difficult problem. Seller motivations are far and wide, but it is important for an appraiser to incorporate anything which might lie below the surface, as seen through the eyes of the owner.

Conclusion

In conclusion, an appraiser’s job in valuing a business, on its face, can be fairly straightforward. The conventional wisdom suggests that a simple review of the published financial data, coupled with an assessment of industry multiples, should suffice in determining value. However, business appraisal is as much an art as it is a science, and it is important to note just how important and influential the “soft” data and details can be in arriving at the final calculated value.

A skilled appraiser will want to understand the various components described in this article, because it helps to paint a more relevant picture and a deeper profile of the company being valued. The output from this important exercise can lead to adjustments in the risk and attribute weightings that are applied within the valuation approaches, which in turn can have a meaningful impact on the valuation. The end result should be a better, more complete valuation encompassing both available information and accessible feedback.