Business Valuation

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Business valuation – adjusted earnings
Posted by: loanuniverse Jan 18 2004, 07:11 PM
From time to time, I get people asking me questions via email instead of posting them in the forum. I have decided as a matter of policy to ignore these questions since only one person gets to read the answers. However, this week I received an email from someone, and I decided to answer it anyway.

I still want people to post the questions in the forum, but this time I made an exception since the topic was something that is not the usual “commercial lending” question and I was feeling gracious at the time ”something uncharacteristic of me smile.gif “

Anyway, let me share the email, and my answer. To protect the sender, we will call him Mr. J. The answer is very general, but it might give other people in the same situation ides.

Mr. J’s question

After reading your 9/2/02 article regarding how to determine the appropriate purchase price of a given business, I have specific questions I’m hoping you can answer. I am currently in the process of selling my existing business franchise through a local broker where the prospective buyer is obtaining sba guaranteed financing. I have a finance background but am not able to speak to the validity of the business valuation done on my business. The lender in this case has derived a value for my business that is substantially lower than what I anticipated. To satisfy my objection, I was given a breakdown of how the number was determined by the analyst and I was left questioning the credibility of what was presented to me. Methods used included the Earnings Capitalization, as discussed in your article, and the Capitalization of Excess Earnings. Each calculation began with an “adjusted earnings” figure that started with last year’s net income, then added back the current owner’s salary (that would be mine, which is about $50M), also added back other expenses determined to be discretionary, and then subtracted out the projected draws to be taken by the buyer, which were significantly higher than what I currently require from the business, as I’m married with a secondary source of personal income.

The end result was that the “adjusted earnings” figure used and then capitalized at a rate of 20% was distorted in my opinion by the inclusion of projected draws of the buyer. The business is worth what it is worth and should not be less valuable do to the buyer’s personal financial situation, right? It was explained to me that the methods used were sba approved but I fail to see how this accurately represents the true value of my business. Is it standard for business valuations to begin with this “adjusted earnings” figure in determing the worth of a business? To include the difference in owner draws?And if so, why? Thanks

My answer:

Mr. J:

I normally ignore people that write to me directly instead of posting in the forum. However, I am in a good mood so I will answer this time around. While it is not possible for me to comment on the specific “business valuation” since I do not have it in front, and I am not really in the business of appraising properties or businesses, I can give you the following comments.

1- The fact that the lender came up with a different valuation should not really be much concern to you from the point of view of selling the business. Did you enter into a contract? Is it contingent on financing? Did you get a deposit?

2- Your business has a higher value to someone that will actually work in it and derive the managerial salary. I tend to agree with you that draws should be left out of the equation. However, doing so would require that the owner’s salary not be added. Doing a valuation like that would show what a prospective owner with minimal involvement would value the business at. You need to crunch some numbers and see if this is an argument you can bring up.

3- You can also benefit from bargaining on the cap rate.. 20% seems a bit high. How long have you been in business? How well established is this particular franchise? Just an example: using a 15% cap rate results in about a 33% higher valuation.

Remember that I am not an evaluation expert, and the kind of deals that I work with rarely require us to do anything like that. Most business loans are based on cash-flow and the probability of repayment. Using a valuation as a source of repayment would be usually tertiary or secondary at best. Furthermore, the value of business assets is pennies on the dollar for a lender.

Hope this helps
Author: Commercial Loan Underwriter