Who’s Best to Determine Business Value?
Financial institutions often have their outside commercial real estate appraisers allocating real property, tangible personal property (FF&E) and intangible personal property/business enterprise for certain property types like hotels and c-stores. However, how appropriate is it for commercial appraisers to determine business allocation? Should other professionals provide this allocation?
According to the Appraisal Institute’s A Business Enterprise Valuation Anthology 2nd Edition, going concern typically includes tangible property as well as intangible property typically being reputation, workforce, contracts, copyrights, patents, trademarks, other assets and residual dollars, which when positive, is profit. Often times these assignments involve an allocation among the component parts of real property in tangible and intangible personalty. Capitalized economic profit (CEP) is defined as the present worth of an entrepreneur’s economic (pure) profit expectation that is included in the residual in tangible category.
I love to watch Marcus Lemonis’s show, The Profit. While it may be overly simplistic for business valuation, I think his trifecta mantra of people, product and process is important to the overall business valuation determination. Having excellent staff and a good product is obviously important. However, as a commercial appraiser, are you actually going to call the companies’ clients to determine how they are treated by the employees or how much they like their products? Probably not. Are you going to invest enough time and have appropriate access to determine the quality of the businesses’ processes? Probably not.
There is a lot of leeway in the educational material available and so commercial fee appraisers are left to fend for themselves to some degree. For example, some hotel specialists consider that the franchise fee is an indicator of business value, while others may determine the average daily rate (ADR) and seasonally adjusted occupancy difference for a flag versus non-flag hotel to estimate business value. What happens when the financial institution’s analysts don’t know what the impact of losing a “flag”? What if the fee appraiser considers that as well as potential retrofit costs and the value of the real estate component is substantially less than everyone proforma’d?
A friend of mine, Ed Valaitis, CBI, CMAP and CVB owns a merger and acquisition intermediary firm known as Edison Avenue. He spends his days facilitating business buyers and sellers. He typically needs financial documentation of the business’s history and current financial trending including 3-5 years of tax returns, year-to-date financials, equipment lists, lease agreements and a deep understanding of the business model. Business valuation experts strive to give a more reliable indicator of value than generic rules of thumb like 10x EBITDA.
His valuations are based on an honest, unbiased look at where your business is in the business cycle and its marketability. Other factors impacting value include: location, competition, regional demand factors, lease terms, type of buyer, supplier relationships, scalability of business model, profit margins, revenue concentration and recurring revenue. He believes the greatest factor in the valuation is often the quantity and reliability of the cash flow a business has generated to ascertain its future potential.
Ed cites that 75% of business owners don’t know how much their business is actually worth. This is supported by a recent IBBA (International Business Broker Association) study, which had similar numbers. Ed shared this; “One of the most astonishing things I learned early in my career is that businesses don’t appreciate in value over time. Businesses are a living and breathing entity where value can be created or destroyed very quickly. When a particular business is acquired it may have fairly been valued at $2 million, but six months after merging with another firm it may only be worth $500,000.”
Are commercial fee appraisers the ones who should be making business allocations? Should that be left up to the credit analysts in the financial institution? Should fee appraisers have more access to collaborate with their client (the bank) who has more detailed information on the business? Would fee appraisers be smart to become better educated in business valuation? Seems to me, these are important questions that the industry should be taking on. But maybe not if going concern values aren’t all that important in commercial real estate loans. If you would like to chime in on this topic or any other topic, please do so, I can share ideas and thoughts on the how and who of business valuations. Thank you.