One common reason business people get their businesses appraised is gift and estate taxes. Grants of business ownership interest by living owners to family members trigger gift tax liability. If the owners pass away, the business is inherited by the younger generation. One of the first tasks for the new owners is how to handle the very large estate taxes. With estate tax rates approaching 50%, the tax bite may be very painful.
Business valuation results: high or low?
Usually, business owners are interested in the highest business valuation possible. This is certainly the case if the business is to be sold to a third party. The same desire for high valuations applies if you consider partner buy-ins, and outside investment, whether venture capital or debt financing.
Gift and estate tax situations are very different. Since the tax is assessed on the current business enterprise value, business owners are interested in the lowest possible figure for their business value.
The tax authorities, for obvious reasons, are skeptical about low business valuations. Experienced tax agents expect that business people want to reduce their taxes – and often retain skilled tax lawyers and accountants to help them do so. Since gift and estate taxes are among the highest, it is natural that business owners would seek the most conservative estimate of their business value.
Tax authorities may develop their own business appraisal. Not surprisingly, the tax man’s business valuation may be quite a bit higher than the owners’ value estimate.
Business valuation: points of contention
Business owners and tax agents typically disagree on what a business is worth on the following points:
- Total business value.
- Discount for lack of control.
- Lack of marketability discount.
Since any business valuation result depends upon the set of assumptions, tax authorities may challenge your business appraisal by questioning your financial forecasts, risk estimates, as well as definition and premise of business value.
Business valuation is always forward-looking. Will the business earnings continue growing at their historic pace of 10% per year? Or will the growth rate stay within 5%, as claimed by the business owners? Will the industry become more risky in the next 5 years? Will the business continue operating or have to exit certain markets and sell some of its assets? Depending on which position is taken, the business valuation results you get will differ considerably.
Whether the assumptions of business owners or tax agent are more accurate, only time will tell. The business valuation result needed today may become a matter of dispute between the owners and tax authorities. And if the two sides cannot develop a reasonable compromise, these situations often end up in court. To avoid the costs of litigation, it is best to work out a solution acceptable to both sides.
Marketability discount and private business sale comps
Tax authorities generally understand that private business ownership interest is less marketable than public company securities. The question often is the amount of marketability discount that applies. Again, the owners tend to argue for higher marketability discount percentages.
This is where private business sale comparable data comes in very handy – if you can show the selling prices of similar closely held businesses, the fair market value of your business is much easier to defend.
Control premiums and minority discounts
If the value of partial business ownership interest is disputed, you can work up a reasonable minority discount by citing the control premiums paid for business acquisitions in your industry. Most sales of public company stock are minority ownership transactions. On occasion, a controlling ownership interest is acquired. The offer terms are publicly disclosed and typically state the price per share – which often includes a premium over the current share market price.
Alternatively, you can value the business ownership stake directly by using the Discounted Cash Flow method – and calculating the present value of the expected returns to the minority shareholder.
If you are looking at valuing an owner-operator managed small business, then the Multiple of Discretionary Earnings business valuation method should be high on your list of priorities.
One of the best examples of the so-called direct capitalization valuation methods, this method determines the value of a business as a multiple of its discretionary cash flow.
One of the greatest strengths of this well-known business valuation method is an excellent match it provides between the business earnings and a broad range of financial and operational performance factors.
You can get very accurate business valuation results with this method. Equally important, you can see how the business value is affected by the quality of the operation.
Balance sheet inputs that affect business value
For highly accurate results, you also need to provide several financial values from the company’s recast balance sheet. These include:
- Net working capital.
- Non-operating assets.
- Long-term liabilities.
For the purposes of your business valuation, Net Working Capital is the difference between the business current assets, less inventory; and its current liabilites, less the short-term portion of the long-term debt. Essentially, this represents the liquid capital used by the business owners for short-term financing.
Non-operating assets may include such items as business-owned real estate, excess inventory and underutilized production or distribution capacity. The idea is that the business asset base should be adequate to support its level of earnings. All assets that are not used to generate these earnings are extra – and can become additional and valuable parts of a business acquisition.
If you value a debt-free business, the long-term liabilities are zero. However, if the business uses financial leverage, then your business valuation must factor in these liabilities. The result is the value of business owners’ equity interest in the business.
If you bought or sold a small business before, you may notice that Multiple of Discretionary Earnings method measures the business value on an asset sale basis. In fact, most small business sales are asset transactions.
In these cases, the business assets, less cash and trade receivables, transfer to the buyer. The seller pays off all business liabilities to deliver these assets free and clear. Non-operating assets may be valued separately and included in the deal.
If you ever tried raising debt capital from a bank, you know that lenders base their decisions on business cash flow. In other words, the key consideration is whether the business can repay the loan in full and on time.
Lenders build in the risk into the debt service coverage ratio. This gives the bank the extra margin of safety if the business earnings dip temporarily. Typical DSCR expected by commercial lenders is in the range of 1.25 – 1.5.
Banker’s main worry: default
In addition, banks expect that some loans may go sour. To address the risk of default, your bank will look for some collateral. Business owners can expect that only a fraction of their business asset values can be pledged as a loan collateral.
Typical business asset values as loan collateral
Accounts receivable, adjusted for uncollectible bad debt may fetch close to 75% of their book value, the finished goods inventory around 50-60%. Hard business assets such as furniture, fixtures and equipment (FF&E) are likely to be worth about 50% of their fair market value when offered as collateral.
Some banks may even be willing to accept certain intangible assets, especially the readily marketable trademarks, copyrights and patents. If a licensing agreement is in place, you can use the Discounted Cash Flow method to determine the value of such assets. Otherwise, you will need to research typical royalty rates and prepare a defensible income forecast for your intangible asset valuation.
Lenders: what are the business assets worth in a liquidation
Business owners and lenders often disagree on the value of business assets used as business loan collateral. The reasons are obvious: from the lender’s perspective a low-risk loan is one offered to a business with plenty of stable cash flow backed by a valuable, highly marketable asset base.
If the loan goes bad, the bank will look to dispose of these assets quickly. Hence, your lender is likely to use the so-called liquidation premise when valuing your business assets.
Business owners: what is the cost to replace business assets?
The fair market value of these assets can be considerably higher. Business owners often object to the lender’s business valuation results – after all, they know what their inventory is worth when sold in the normal course of business. Besides, it seems far more reasonable to value the FF&E on a replacement cost, value in use or going concern basis.
Different assumptions lead to differences in business valuation results!
Whose valuation is right? Actually, both sides are correct! As is the case with any business valuation, the assumptions drive the results. Put differently, the business owners and the lender use different premises of value – each based on their respective position.
Both the lender and business owners need to understand that this business value spread is normal, then work together to find an acceptable compromise.
If you own a car wash business or looking to buy one, here is a piece of good news: car washes are one of the most profitable sectors of the service industry with above average profits. These businesses are known to generate steady income due to the necessary and recurring nature of the service they offer.
While changes in car designs and energy alternatives may have lasting effect on many auto service businesses, the car wash will continue to provide the same basic service. This, of course, means that you can expect the revenues in the car wash sector to continue growing steadily.
The car wash service is a typical small business industry: classified under SIC code 7542, there are over 29,500 car washes in the US alone. The industry generates a very respectable $4.4 billion each year in gross sales and employs just under 138,000 people. Yet the average car wash is quite small, employing a staff of 5 and having the annual gross revenues around $200,000.
Established, profitable car wash operations are very marketable – the up-front investment of starting a new business can easily tip $2 million! Buying an existing business offers a very attractive alternative of immediate cash flow and steady business growth prospects.
Car wash businesses come in several types: the self-service, conveyor and the highly automated in-bay. The more profitable establishments tend to offer additional value-added services which include on-site detail services, gift and coffee shops, and periodicals for sale.
Business valuation methods for car washes
Given that car washes sell often, there are plenty of market comparables data to do your business valuation. Typical pricing multiples used are selling price to gross annual revenues, discretionary cash flow or EBITDA. The price to cash flow multiples are especially well suited for valuing a business with the above average profitability.
Valuing a Business using Market Comps
Well-established car washes may have considerable goodwill. In these cases, the Capitalized Excess Earnings method is an excellent choice. In addition to showing the value of the business and its tangible assets, you can use this well-known business valuation method to demonstrate the value of business goodwill.
For younger car washes or businesses in a rapid expansion mode, the Discounted Cash Flow business valuation method may be more appropriate. You can demonstrate the value of a business to partners and outside investors based directly on your earnings forecast and risk assessment.