The Valuation Process An Interview with Shannon P. Pratt

This article is reprinted with permission from SmallBusinessLearning.net The Valuation Process An Interview with Shannon P. Pratt Often called the "architect of modern business valuation theory," Shannon P. Pratt, D.B.A., F.A.S.A., CFA is the author of Valuing a Business: The Analysis and Appraisal of Closely Held Companies and Valuing Small Businesses and Professional Practices. Dr. Pratt is managing director of Willamette Management Associates, a national business valuation firm headquartered in Portland, Oregon. The Editor of the Small Business Forum recently asked Dr. Pratt to discuss the valuation process. Forum If a small business owner would say, "Dr. Pratt, I'd like to sell my business," where would you begin? Pratt I would begin by suggesting that they ask a professional to do the appraisal. Generally, that business is the most valuable asset they own, and it's very important to get the best possible price that they can get for it. Forum Why do you recommend going to a professional appraiser as opposed to other sources for advice? Pratt: For several reasons. Briefly, you shouldn't rely on rules of thumb because they aren't based on fact and because they tend to be overly optimistic. Conditions change, and an appraiser can help evaluate that. An appraiser can help business owners understand the trade-offs between cash and terms. Finally, there's a greater tendency toward lawsuits, so people just have to be more careful. Forum: Let's discuss each of these in more detail, starting with rules of thumb. Pratt: Typically, they're very, very misleading. And when you get down to actually applying them, they don't work. Let me give you two examples. The first is in the property management business, which is the business of managing apartment houses, condominiums, office buildings, and all that sort of thing. They have a trade association called the Institute of Real Estate Management (I.R.E.M.). That institute hired me to make a study for their membership on the sales prices of the businesses in their industry. I had the full support of the trade association. I did a survey of the prices at which they expected their businesses should sell. Then, at the same time, I did a survey on actual sales. And because of the industry sponsorship of this survey, I was able to get excellent results. We got information on over 100 actual sales of property management companies. On average, the actual sale price was approximately two-thirds of the price that would have been indicated by the rule of thumb. I had another similar situation, where the subject was a franchise of car rental agencies. Now, in this particular case, the survey was even more comprehensive because they were franchises, and we were able to get a complete list of every one that was sold over a period of ten years. And I did a similar sort of an exercise. My staff and I surveyed the owners of these franchises to get their perception of the prices at

which these agencies should be expected to sell. In this particular case, the net result was that the actual sales were approximately 50 percent of the prices that would have been indicated by the rules of thumb. Forum: So the rule of thumb formula was very misleading. Pratt: The pricing of the business is very complex. In my experience, sellers probably over price more than under price somewhere between four to one and ten to one. In other words, the tendency on the part of sellers is to over price. Forum: Continuing now with your list of reasons to hire a professional appraiser, you mentioned that conditions change. Pratt: Conditions do change, and they change quite drastically from time to time, for the economy as a whole, and for the economies in specific areas and for particular kinds of businesses. As interest rates go up, and as money gets tighter, the value of businesses goes down. When there are a lot of businesses in a certain industry for sale, and fewer buyers, the value goes down. When there are a lot of buyers and fewer sellers, the values go up. And these changes can be quite drastic. For example, in the restaurant industry, the largest broker in one city told me about a time when the average selling price declined 30 percent within six months. Forum: Thirty percent! Pratt: Thirty percent, within six months. So these rules of thumb are not good over time. Forum: So, a one million dollar restaurant could become a $700,000 restaurant in six months? Pratt: That's right. Forum: What about the trade-off between selling for cash and terms? Pratt: Typically, small-business transactions are not cash transactions. Usually, the owner gets a small down payment and then finances the balance of the purchase on terms and at a rate at which no bank would loan the money. So the real cash equivalent purchase price tends to be much less than the so-called rule of thumb price. So, an important benefit that the business owner can get from an appraiser is an understanding of the trade-offs between cash and terms. For small-business owners, that is a very, very important consideration. Forum: So, for example, a million dollars in cash today is more than a million dollars paid over 10 years at two percent lower than prevailing interest rates. How much more? Pratt: The difference is $180,000. Just two percent difference in the interest rate over a 10 year period makes a difference of $180,000 from the present cash equivalent value! So you can see why this is an important point. I give the subject an entire chapter in my book. Forum: You mentioned that there is a greater tendency towards lawsuits. Pratt: That's right. That's one of the major legal trends I've observed. You have to be more careful because if the business goes bad after the sale, the buyer may want to come back and sue the seller. You have to be careful and disclose everything there is to disclose. Don't hide anything. Make sure that the buyer is in fact fully informed of all the relevant facts. People who are involved as parties to transactions simply have to take

more precautions. They have to do things more professionally. They have to get a good, solid professional appraiser and a good, solid lawyer. The profession of business appraisal has become much, much more recognized in the United States, especially within the last three years. Forum: How does one select an appraiser? Pratt: Well, I would say that first of all, there's a group called the American Society of Appraisers. They put out a directory of accredited senior appraisers in business. These are accredited senior appraisers in business appraisal, located in virtually every city in the United States. And the Society will send the book out free of charge. So if you don't know anybody locally, then that is probably the best place to start. (Editor's Note: To request a complimentary copy of this booklet, which lists 500 accredited members, call 1-800-272-8258.) Forum: What type of background would a business owner expect the appraiser to have? Pratt: Typically they're going to have a college degree; usually, but not always, it'll be in business administration. Ideally, the major would be finance. Now, they may have gotten their academic training in finance at the graduate level as opposed to the undergraduate level, but typically they would have that. I think, however, that even more important than the formal academic education would be the professional credentials. And for small businesses, the primary professional credential is A.S.A., which stands for Accredited Senior Appraiser of the American Society of Appraisers. You'd want somebody who keeps up professionally on the subjects of appraisal. Forum: What could business owners expect in terms of a time frame, at the time that they first approach appraisers? Pratt: It depends a lot on how good their books and records are. Let me call your attention to an exhibit that's in my book, Valuing Small Businesses and Professional Practices, which lists the material that the owner should have prepared to hand to the appraiser. (See Figure 1 below) Forum: So, for example, if they have an up-to-date business plan, and five-year projections, the time frame would be considerably less. Pratt: It would be considerably less. It probably also would be considerably less to get the sale made and it probably will help them insure that they'll get a full fair price. All those things will help with the appraisal time, the time to sell and assurance of getting the price they ought to get. Forum: Now, if they don't have those things on hand, would it be best to ask the appraiser to guide them through the process? Pratt: Absolutely. And when the appraiser looks at it, it may be that the appraiser will recommend that they need to have some accounting work done. Then you get into the situation where in some appraiser's offices you would have someone who may be in the position to provide the accounting service. With other appraisers, they might suggest that you go to a CPA firm. So, that will vary depending on the appraiser, but the appraiser can give them the guidance. And although it may slow down the process for the seller to get good books and records, it certainly should pay for itself many times over. Forum: So that would be a good investment.

Pratt: One of the very best things small-business owners can do is to get their house in order, to get their books and records in excellent condition. And get all the superfluous stuff out of there. Get Grandma off the payroll, get a lot of the personal perks out of there and get their inventory records up to date and all those good things. In other words, if an owner is contemplating selling, even as much as five years into the future, it's not too early to start now to tighten up the operations. Forum: Does it also help to think in terms of selling the business during the five years previous to the sale, too? Pratt: Absolutely. And naturally, all the good things you do to make your business good, are good anyhow. But a lot of the housekeeping things and particularly the books and records and the accounting things are important, and I just can't stress that too much. If they have five years of excellent records, they're going to put themselves in a good position when it comes time to make that sale. Very few businesses accomplish that. Forum: It's a very time consuming matter. Pratt: But it helps them run their business better anyhow, so it's not just an investment for the sale. It's good business to do it anyhow. Forum: So, if a business has the materials in hand that you include on your list, and goes to an appraiser... Pratt: Typically then the appraisal can be done in 30 to 60 days. Otherwise, you may be looking at a 60 to 90 day time frame. Forum: What about family businesses that are selling to the next generation? Pratt: In that case, the appraiser and the owner have got to work very closely together I've done many of these, and it depends upon the objectives and the financial situation of the parties. In some cases, the owner is going to say, "Well, I don't want to sell it to my family for any less than I can sell it if I put it on the open market." On the other hand, some sellers are going to take the attitude, "Look, I want to sell it to my family and I've got all the money I need, really, and so my primary concern here is that I don't run afoul of the tax authorities." If the business is worth a million dollars and he sells it for $500,000, he will get stuck for taxes on a gift for the difference. So you may have a different focus there and if it's going to be somehow transferred to an insider or a related person, then the appraisers need to pay particular attention to the tax laws to make sure they won't run afoul of the tax laws. All good business appraisers are well informed about these things. Forum: In your experience, are there other complexities with family businesses, in addition to the tax laws? Pratt: Yes. Tax laws, of course, are extremely important. Another item is whether any kind of a buy/sell agreement exists. This depends on whether a potential family-member purchaser may have either worked for the business or already had some stock or a partnership interest in the business. Buy/sell agreements come in so many varieties, with so many different provisions, it's very hard to generalize about them. The appraiser certainly needs to take those into consideration and be sure that all the parties are satisfied. Now, another thing that you have in family businesses is different parties who may have differing objectives. I can't tell you how many

internal family situations I've seen where a son sues a father or a brother sues a brother or whatever over a family business situation. Maybe they were promised that they were going to get to buy stock at a certain price and then for some reason it was decided that the second-generation person wasn't good for the business and it didn't happen. I've seen this over and over and over again. So you've got family relationships to consider. And if the business is likely to have three or four generations of family members, then these things get a lot more complex because by the time you get into the third generation, a lack of family motivation among the parties is typical. A good, experienced business appraiser will have had lots of experience with all these different complexities. One of the things a business appraiser can do in talking with the parties is to discuss all these family relationships, draw on past experience, and help prevent these kinds of problems. Forum: I see. So, in the case of a family business, it is important to start very early with succession planning, even more so than in other businesses? Pratt: Oh yes, I think so. Forum: What would be a good benchmark time? Fifteen years before the sale? Pratt: Well, it could. If the owner wants to minimize taxes, the owner can start the business transfer early and can transfer tax free up to $10,000 of stocks, each year, or partnership interest, each year. So if a husband and wife have four children, then both of them can give $10,000 worth each to each of their children, which means in the scenario I gave you, they could transfer tax-free by gift, $80,000 per year worth of value. When they do that, the IRS requires an appraisal. But typically, for a small transfer like that, the appraisal is not going to be of the same scope and complexity as it would be for an appraisal that covers a transfer of the entire business. Forum: What are the two most important factors that affect small business valuations? Pratt: The number one factor is: how much money can it earn? And this should be in terms of cash flow. How much cash can this business generate? That's the most important thing. And the second most important thing may be the assets that are available. Forum: Which is more important historical data or projections? Pratt: Well, how reliable are the projections? The historical is important, not in and of itself, but as a means of showing what the business has done and providing some backup or reliability or reality to the projections that you're looking at. The reality is that the only thing that makes any difference is how much the business can earn in the future. Forum: I've read that you have said that the most common valuation mistake is in selecting the capitalization rates. Pratt: Oh yes. In other words, when you're capitalizing cash flow or capitalizing income, it's an exercise that has two dimensions to it. Number one is the cash flow stream or the income stream or whatever it is that you're capitalizing. And then the other half of that equation is the rate at which you're capitalizing or discounting it. And it's very important, but the rate is much higher than most business

owners have any idea that it is. And that's one of the reasons why business owners tend to have an overly optimistic idea of the value of their business. They often use too low of a rate at which to capitalize the cash flow or the earnings. As the capitalization rate goes up, the value goes down, and vice versa. So that is one of the biggest problems. Certainly the rate for ownership has to be higher than the rate at which you can borrow money at the bank. Forum: That's an important point. Can you explain why? Pratt: The bank's going to protect itself. It's going to get assets, it's going to get collateral pledged to it and everything else, such as limitations on salaries and bonuses, for its loan. If you're buying into the business, you're buying ownerships and you are incurring risks beyond the risk the bank is incurring in making a loan. So you have to have a higher expected return. In other words, it isn't just a government bond rate and it isn't just a corporate bond rate, and it isn't just the bank's prime rate. It's got to be what that little business can borrow at, plus something more for the risk. Forum: An essential fact that may be lost in the other calculations. Pratt: Absolutely. I can't tell you how many times I've seen people, particularly accountants, do a real good job on the projections and then just capitalize at something like 10 percent, which is almost a risk-free rate, while they probably should be capitalizing at something more like 20 percent. So if you capitalize at 10 percent when it should be 20 percent, you've suddenly doubled the value, or doubled the indicated value. Forum: Let's say that a business owner has gone to an appraiser and has finished the appraisal process. What do you recommend next? Pratt: Step two is to get a good business broker. The appraiser in most cities typically knows who the business brokers are and can refer the owner to a good, solid business broker. Now, interestingly enough, there are certain industries where sales of the business tend to be made without the services of a business broker. This tends to be true in the automobile dealership industry. Most of the buyers of automobile dealerships are people who have either previously owned an automobile dealership or have been a general manager of a dealership. And they know the business quite well. It would be a very, very difficult business for somebody to come in from the outside and invest in. We value lots of automobile dealerships, but very few business brokers broker them. But in most kinds of small businesses, the seller will do better if he uses a reputable business broker than if he does not. Forum: How can I find a reputable business broker? Pratt: I would tend to recommend one who is a member of either the International Business Brokers Association or the Certified Business Counselors. Forum: I'd like to summarize the main points. You said that the two most important factors in valuation are cash flow and assets, that it is important to plan ahead, and that there's a difference between cash and terms. You described how interest rates influence value. And, you recommended going to a professional appraiser because rules of thumb are inaccurate, conditions change, and because the appraiser can provide a more sophisticated analysis that can stand up in court.

Thank you, Dr. Pratt, for taking us through the valuation process. Figure 1 Documents and Information Checklist for Valuation of Business or Professional Practice Financial Statements Balance sheets, income statements, statements of changes in financial position, and statements of stockholders' equity or partners' capital accounts for up to the last five fiscal years, if available. Income tax returns for the same years Latest interim statements if valuation date is 90 days or more beyond end of last fiscal year and interim statement for the comparable period the year before List of subsidiaries and/or financial interests in other companies, with relevant financial statements Other Financial Data Equipment list and depreciation schedule Aged accounts receivable list Aged accounts payable list List of prepaid expenses Inventory list, with any necessary information on inventory accounting policies (including work in progress, if applicable) Lease or leases (if lease does not exist or is not transferable, determine what new lease or rental terms will be) Any other existing contracts (employment agreements, covenants not to compete, supplier and franchise agreements, customer agreements, royalty agreements, equipment lease or rental contracts, loan agreements, labor contracts, employee benefit plans, and so on) List of stockholders or partners, with number of shares owned by each or percentage of each partner's interest in earnings and capital Compensation schedule for owners, including all benefits and personal expenses Schedule of insurance in force (key-man life, property and casualty, liability) Budgets or projections, if available Company Documents If a corporation, articles of incorporation, by-laws, any amendments to either, and corporate minutes If a partnership, articles of partnership, with any amendments Any existing buy/sell agreements, options to purchase stock or partnership interest, or rights of first refusal Other Information Brief history, including how long in business and details of any changes in ownership and/or bona-fide offers received Brief description of business, including position relative to competition and any factors that make the business unique Marketing literature (catalogs, brochures, advertisements, and so on) List of locations where company operates, with size, and whether owned or leased List of states in which licensed to do business If customer or supplier base concentrated, list of major accounts, with annual dollar volume for each List of competitors, with location, relative size, any other relevant

factors Resumes of, or list of, key personnel, with age, position, compensation, length of service, education and prior experience Trade associations to which company belongs or would be eligible for membership Relevant trade or government publications Any existing indicators of asset values, including latest property tax assessments and any appraisals that have been done List of patents, copyrights, trademarks, and other intangible assets Any contingent or off-balance-sheet assets or liabilities (pending lawsuits, compliance requirements, warranty or other product liability, and so on) Any filings or correspondence with regulatory agencies Information on prior transactions SOURCE: Willamette Management Associates, Inc. Reprinted from Valuing Small Businesses and Professional Practices with permission of the author. Figure 2 Differences between the Valuation of Large and Small Businesses Status of Financial Statements Larger companies are more likely to have statements that are audited, or at least reviewed, by outside CPAs, while smaller businesses are more likely to have statements that are merely compiled. Cash versus Accrual Accounting Most large companies use accrual accounting, while many small businesses use cash accounting Length of Track Record Available On the average, larger businesses have longer histories available for analysis by the appraiser. Form of Business Ownership Large operations are more likely to be regular corporations, while smaller operations are more likely to be sole proprietorships, partnerships, or S corporations. Stock versus Asset Transaction The larger the company, the more likely it is that stock is to be transferred in case of a sale, while a smaller entity is more likely to involve a transfer of assets. Consideration Offered by Purchaser The smaller the business, the more likely it is to be sold for a cash down payment and a term contract for the balance; the larger the business, the more likely it is to be sold for cash and/or stock in a public company. Comparative Transaction Data Available The smaller the company, the fewer the comparative transaction data that are publicly available; while for valuations of larger companies, it is much more likely that useful, comparative, publicly traded stock data will be available. Role of the Owner/Manager The smaller the company, the more important the role of one or a few owner(s)/manager(s).

Compensation to Owners Larger companies are more likely to remunerate owners at something near a market rate of compensation, while small companies tend to pay owners what they can afford, which may be above or below a market rate. Accounting Policies for Financial Reporting Smaller firms usually have a single set of financial statements, normally following whatever accounting policies minimize their tax liabilities. Larger companies are more likely to have a set of financial statements designed to present a truer picture for financial reporting than their tax statements would convey. Earnings Analysis on Pretax or After-Tax Basis When valuing a large corporation, you usually state earnings and cash flow figures on an after-tax basis. When valuing small businesses and professional practices, the opposite usually is true; that is, you usually state earnings and cash flow figures on a pretax basis. Complexity of Capital Structure Capital structure is generally defined as the equity (ownership interest) plus the long-term debt. Smaller entities tend to have simple capital structures; larger ones are likely to be more complex. The person doing the valuation should determine whether there are any complexities in the capital structure. Reprinted from Valuing Small Businesses and Professional Practices with permission of the author. This book and Valuing a Business (which is aimed at businesses worth over $1 million) are available through Willamette Management Associates, Inc., 400 South West 6th Avenue, Suite 1115, Portland, OR 97204, (503) 222-0577. Shannon P. Pratt, D.B.A., F.A.S.A, CFA is often called the "architect of modern business valuation theory." Dr. Pratt is the author of Valuing a Business: The Analysis and Appraisal of Closely Held Companies and Valuing Small Businesses and Professional Practices. He is also the co-author (with Jay Fishman) of Guide to Business Valuations. Dr. Pratt is managing director of Willamette Management Associates, a national business valuation firm headquartered in Portland, Oregon. Description: Shannon P. Pratt discusses how small-business owners should begin the process of selling their business. This article is reprinted from the Small Business Forum, the journal of the Association of Small Business Development Centers, which is published by the University of Wisconsin- Extension Small Business Development Center. For information about subscriptions, reprints or submissions, please write 432 North Lake Street, Room 425, Madison, WI 53706, or call (608) 263-7843. Developed by the University of Wisconsin Small Business Development Center. For further assistance, contact a consultant at a Small Business Development Center.