EP 114: Does your Business Valuation Help or Hurt Your Chances Selling Your Business?

Ed Mysogland  0:19  
Welcome to a another episode of the defenders of business value podcast. I'm your host, Ed Mysogland. Today's topic is is really, honestly interest. I mean, it is certainly interesting. I mean, the biggest thing, and what's prompting This podcast is that I'm getting more and more business valuations. And the good news is that a lot of business owners are beginning to talk to professional advisors about their sale about their business value. And while that's good, the problem is that we're bumping into the value that the appraiser is rendering is not applicable for sale purposes. And so in today's podcasts, that's what I want to talk about is figuring out and showing you why and how you want to approach your business valuation. Alright, so let's let's, let's begin with you know, business valuation. Alright, so for those of you that, that aren't watching, so I have a slide up, and there's various, there's five different types of hammers that I have. All right, and each one of them can certainly pound a nail. But each one is used for a different purpose. And it's the same, it's the same thing I want you to think about when when you have appraisers, so the appraisers, you you have business valuation for litigation, estate and gift, you have it for divorce, you have it for folks like me for sale purposes. You have intellectual property and trademark. And then you have you have industry specialists. So, so how, how does advisors go off, go go go off the road. So the slide that I'm showing now is it has to do with the standard of value. And we're going to talk about the different standards. And everybody thinks fair market value is what's applicable for selling the business and it is not. So let's talk about, you know, if and this next slide, I have, I have a a, it came from an article from like, it's the Wall Street Journal, about, you know, Trump's own witness, in his, in his fraud case admits he knows nothing about finances. And the biggest thing I wanted to draw here was that, you know, Steven lipids first stand on Thursday to discuss the valuation of Trump's real estate holdings. i The so he's been he's been accused of inflating his his market assets. So poza. You know, LiPos, then says that he relied on the market value analysis of Trump's properties, he agreed that he should have based it on investment value, which takes in consideration of the owners investments or investment requirements. So back to the standard of value, he totally missed that this appraiser totally missed the purpose for which he was hired for. Alright, so standard value. Alright, standard of value is in many situations, it's legally mandated by the law. All right. And I'll talk to talk in a minute about some of the areas that we need to know the areas in which regulatory bodies oversee valuation. In other cases, it depends on you know, the parties wishes, like for example, you know, the bank, the bank wants to know about collateral they don't care about. They they don't care about market value, they care about, you know, what's if this thing goes bad? What's it worth, you know, so, in business VAT in the standard value, it addresses the question value to whom and under what circumstances and this standard of value helps determine what valuation methods are appropriate, and what factors should or should not be considered for the purpose that you're doing the valuation. So this, this next slide, which is probably The most important slide I kind of cobbled it together from from a book called private capital markets, and then I and then I kind of overlaid my own take on it. So the standard of value. Let's first talk about transfer channels. Transfer channels means how you're going to how you're going, how there's going to be a change of ownership. So we begin going left to right. Liquidation estate and gift P retaining them, you retain as an investor, you sell to your employees, you got a family sale, you got partners and partner buy sell, you got Aesop's, you got outside sales, which is can be a third party exit or recapitalisation. And then lastly, you got pup a public offering, so an IPO. So, those first six are internal transfers in the last three are external transfers. And what you see across the very bottom, from going from left to right, so liquidation is orderly liquidation value, the state and gift is fair market value retain an investor chances are its fair market value sale to an employee's fair market value. Family sale, probably fair market value, partner, partner buy sell, fair market value or something negotiated ESOP certainly fair market value, then you move to outside to third party sales and exits and recaps, that's investment value, and then public offerings also investment value, or intrinsic value, as some people call it. So you can see that the bulk of of fair market value appraisals, you know, are for, you know, roughly 70% of the transfer channels, only sale and public offering our investment or intrinsic value. So now, you this next slide that I'm showing, you know, estate and gift is fair market value purchase and sales, investment or market value, marital dissolution, it's dependent upon the state, but chances are it's either fair value, which means no discounts or fair market value, which means discounts, buy sell agreements, they can do anything. They want dissenting shareholders. So that's fair value, minority oppression, that's fair value. Aesop's or employee stock ownership plans is fair market value. ad valorem taxes, generally fair market value going private fair value in most states corporate or partnership dissolutions. Fair Value, maybe even fair market value depending on the statute, antitrust, it's dependent. It's case law dependent. Other damages against statute and case law and financial reporting is fair value as defined by FASB. So this chart came from a buddy of mine, Paul, watch up watch valuations and it's a it's a real good summary of the applicable standard of value. Alright, so fair market value this, to me is the culprit for all of my woes. It's the price which which a property would change hands between willing buyer willing seller when the former is not under any compulsion to buy? And the latter is not under any compulsion to sell both parties having a reasonable knowledge of the relevant facts. And that's from revenue ruling. 5960. Right. And that, that revenue ruling, its purpose was for prohibition, I couldn't remember what the what, how this whole thing started, where, where, where the government was evaluating how to tax tangible and intangible property. And so this revenue ruling came out and was from then on the proxy for fair market value. Okay, but here's the problem, that there is a fair market value, and then there's the real world. So in fair market value world, it's hypothetical. We just heard you just heard the description. It's fair market. It's hypothetical. It is the buyers are plentiful, and they're acting on their own self interest. So, the first thing is, look, they this is real world, these are real buyers, and they may be plentiful or they may be limited and they may or may not be meaning the buyer and the seller may or may not be acting rational. You know, when when negotiating or working on reaching a value

Ed Mysogland  10:01  
Next, you know, is it arm's length? All right, buyer and seller are independent both or act accordingly in the real world, you know, is it really arm length? Well, there are various elements of compulsion, duress and such and exclusive there, there may some one of them, one of the parties buyer or seller may have knowledge giving them a negotiated competitive advantage. So, again, fair market value out the door, are they willing to trade again, buyer and seller are hypothetical buyer and seller both willing to enter into that transaction, and there is no willingness there that does not even factor in. And we bump into this a lot with with divorces, like people show up at our doorstep. And because we sell businesses, that means that we are the immediate arbiter of value, and like you, you heard it at least in our state, we're a fair market value state. So, so we're using hypothetical parties to determine fair market value in for sale purposes. You know, we're, we're evaluating whether or not you know, these are real, real parties that are really, you know, app to behave in a manner for their own self interest. So, so when we talk about, you know, are they hypothetical, that they're, they're willing to enter into a transaction, and they're, under any circumstance, the unwillingness to transact is not present. That's not the case, in the real world, deals fall apart for all kinds of reasons at all, at all different stages of the process. So now, reasonable knowledge, fair market value says, you know, what we have, we are totally informed for about the business. You know, they and both parties are knowledgeable of alternative investments, if I'm not going to do this, why, you know, I can go elsewhere and get the same return. In the real world, you know, Either party may or may not have sufficient knowledge about the business and the market. And you know, how it's going to grow. And again, you remember, I preached this valuations based on earnings, growth and risk. And so the real world, you know, the buyer or the seller may have inside information, then I don't mean, inside, like insider trading, but inside information about the industry or the business or where it's heading, that could could influence value. All right. So now, absence of compulsion, under fair market value, we say, you know, what, if the price is right, everybody's going to transact. In the real world. There's a variety of reasons. You know, there's business planning, retirement, merger, merger and acquisitions, selling outside advisors, or outside investors, I'm sorry, getting a divorce bankruptcy IPO, there's a whole reason and a whole series of compulsions that, that affect value. And so when you when you look at if the price is right, it's probably, again, back to the everybody's everybody's obligated transact. In the real world. It's not, and the reason for sale will affect the value. I recently did a did an article about value penalty, if you want, you can look it up on LinkedIn, based on the the type of reason for sale, like for example, if you're retiring, that's a perfectly legitimate reason to sell. Conversely, you know, if there's a death or a divorce, there's going to be a value penalty from a sales standpoint. So All right, next negotiating skills. Both parties have similar negotiating skills in the real world. It depends on who's coming to the, to the, to the table. You know, there's a lot, you know, we talk about, you know, can you do this yourself? Yeah, maybe you can probably sell your business yourself. That probably is in your best interest to surround yourself with some pretty good advisors. Only because many buyers have many more opportunities to have bought businesses then you've had to sell. But my point is that the negotiating skills under fair market value, you know, that's not a material issue about what They're not about value. In the real world, it really depends on who's the party, who the parties are, that are going to be at the table and, and operating on your behalf. Economic Factors tight. So this is based on the merits of the investment, comparing it to alternative investments, the know, it's known as the principle of substitution. But the real world out there may it the economic factors may be strategic may be synergistic, emotional or financial, or a combination of all of them. And that influences value. And so, I was, for example, we were, there's a, a business that prints money, but he's the practitioner, he, he, he knows everything about that business. So he has, he's a one man band, but prints money. And, you know, what is the economic factors are, who's going to buy. So from a strategic standpoint, somebody can just grab a hold of them, assuming that he's willing to stay or train somebody to transfer that knowledge. So that's a strategic or a synergistic motivation. The emotional one is, you know, we've had buyers that don't want, you know, that have fallen in love with businesses that they've, they've patronized over time, for example, we have, in one of our, one of my podcasts, a number of people say, you know, when you're selling your business, look to look to your evangelists that you serve, those might be your buyers. And then lastly, the financial motivations. And that's pretty self evident. So in fair, and this is probably the big killer, is fair market value, they assume cash, cash or cash equivalents. And in the real world, that could be all kinds of different tools, cash notes, earnouts, you know, sub debt, you know, noncompetes, consulting agreements, employment agreements, all of that, and a combination thereof, makes up the deal in the real world. But in fair market value world, it's all cash. And then, lastly, rational markets, you know, it assumes that everybody's rational, in fair market value land, in the real world, I can tell you, after we're, we're north of 22, under deals, and I can tell you that there is all kinds of emotion, and all kinds of irrational behavior toward investments on both sides. Whether it's the buyer that that thinks that they're buying IBM, conversely, this, you know, the the seller that thinks that they have something far superior to anything else on the market, and they behave as such. So, again, rational markets, fair market value assumes that is its present, real world says it's not.

Ed Mysogland  18:21  
Okay, so the market, the marketplace follows the owners goals, chooses the type of buyer. And remember, when I talk about the types of buyers, you know, we had the that that list of nine different transfer channels. But focusing on the sale side, the three different types of buyers are as follows. You've got your individuals or financial buyers, you've got huge buyers, and you have private equity groups, those are the three types of buyers that will facilitate a sale. All right, and those different buyers have different value drivers. And then the business value is relative to each of those different buyers. So meaning a private equity group is looking at the operation of what and by Can I layer, my processes, and my efficiencies and my scaling ability over the top of this business to make it a one plus one equals three deal. All right, versus a financial buyer who's interested in three things. One, can I pay myself two, can I service the debt? And three, can I get a reasonable return of an online investment? All right, so So the different so there's different motivations of each of those types of buyers and you need to keep that in mind. And the most the the takeaway is there for every private company, there are a dozen that and in fact, there's dozens of correct values at any given point in time, just depending on who, who's the one looking. Alright. So that is what I'd like to share today. So when you are working with a professional advisor that's doing any kind of value work, you just need to make sure that the person that's doing the work, understands the reason for it. And anyone that shows up and says, you know, fair market value is, is proxy for, for for business value is probably wrong. Or they're just combining nomenclature. And it just, it just doesn't, I don't want to say it doesn't make sense. But it's not a it's not a useful tool to the seller. So the seller wants a once a number that makes sense to the marketplace. And a lot of times you don't know until you take it to the market. But generally speaking, your business is going to remember, we talked about the the buyer at the bottom, the financial buyer, that's the person that's that is an entrepreneur that's looking at replacing you, okay, can I pay, can I get paid a reasonable wage, I'm not going to leave my $200,000 job to take a $30,000 No, no pay, so I can buy your business and pay you whatever it is you want. It's not going to happen. If market in that industry is $200,000, then that's $200,000 that comes right off your cash flow. And then the balance becomes how much debt can I service? Okay, so that that those are the two the two primary questions with the third beam return on on the investment? How am I going to pay for this deal? Alright, after I pay myself, can I service the debt? And can I get a reasonable return on my my investment? Those are the those are, that's what drives the buy that is at minimum, the sanity check on your business valuation. So those if you can't answer those, and that's what I would encourage you to talk to your appraiser about because they can do the that analysis on that sanity check. And so as we're as we're looking, that's where I would start. And if for whatever reason you need, you need any kind of help. You want me to review somebody else's work. Happy to do that. Do it all day. So I appreciate you taking the time. I hope this episode helped you. Understand a little bit more about business value in the standard of value. We'll see you next week.