Mistaken valuation can set a business back

Knowing what their business is worth is becoming top-of-mind for business owners, but they make seven basic mistakes in their attempt to protect the business and the wealth it generates.

Since many small business owners find themselves in the frustrating position of spending the majority of their time working in the business rather than on the business, a great deal of important planning is delayed or done in a haphazard way.

Recent business research has confirmed this trend. MassMutual’s 2018 Business Owner Perspectives Study found that 70 percent of business owners say they frequently or often think about their business value, but only 13 percent considered a valuation to know if the value of the business will be a sufficient component of their retirement plans. Yet that is one of the most important reasons to do undergo a valuation, according to a panel of wealth management experts interviewed for this article.

Martha Sullivan, partner and succession planning practice leader in the business transition strategies group in the Madison office of Honkamp Krueger & Co., a CPA and business consulting firm, says business owners should consider valuation to be a golden opportunity to work on their business. “It’s a fact that about 50 percent of all business transitions or business exits are forced because of death, divorce, or disability, or a disagreement,” says Sullivan. “So, there is a 50-50 chance that a business owner is not going to be in control as to when they exit the business, and therefore they may not have the opportunity to impact the value of that business in anticipation of the exit.”

Given the mistakes associated with business valuation, we asked an expert panel about this central piece of any successful business exit and succession plan. Our panel consists of Sullivan and the following local executives: J.P. Aime, financial advisor and president of Focal Point Financial Strategies, and Andrew Klein, financial advisor and CEO of Focal Point Financial Strategies; Nathan Brinkman, president of Triumph Wealth Management; Alyssa Chance, vice president-personal trust officer in the wealth management division of State Bank of Cross Plains; and Tim Powers, president/CEO of MassMutual Wisconsin.

They identified seven common mistakes made on business valuation.

Mistake No. 1: Infrequent valuations

If a proprietor has a value firmly in mind, he or she usually is ready to sell, especially if they are certain about the strength of their position relative to the transition to another owner. Those who do not have valuation done on a regular basis don’t have that baseline knowledge and therefore don’t know what needs to be done in order to improve. So, if you’re on the unfortunate side of that 50 percent who are not in control when exiting the business, you could be leaving your family in a difficult position because there is no time to do anything about it. Not only that, you have left a lot of money on the table.

Ideally, valuations should be done annually to understand which drivers make the business more attractive and sustainable in the long run, and to evaluate performance against previously established baselines, but that’s not always possible due to cost. “I’m realistic enough to know that even a skinny valuation, or a less robust valuation by a qualified valuation analyst, could run anywhere between $3,500 and more than $8,000, depending on complexities of business structure,” Sullivan notes. “Doing that on an annual basis is a worthy investment in your business, but for some that may be out of reach, so biennially is also fine.”

If a “skinny” valuation — also called a calculation of value — costs $3,500 to $8,000, what does a more robust valuation cost? According to Sullivan, a more robust valuation — also known as a conclusion of value — can cost between $10,000 and $15,000, again depending on the complexities of business structure.

The purpose of the valuation could force you into having the conclusion of value. Valuing the shares for gifting, estate planning, a contentious divorce, and other litigation purposes requires a conclusion of value from an accredited and experienced business valuation analyst. The Internal Revenue Service, opposing counsel, and the courts will expect this level of report and will seize the opportunity to discredit the valuation to their favor if it’s not delivered, Sullivan warns.

The conclusion of value requires the analyst to consider all three “approaches” to valuation: the income approach, the asset or cost approach, and the market approach. “In a conclusion, the valuation analyst is technically opining on the value of the business,” she notes.

In contrast, the calculation of value most often is used for strategic planning, exit, or succession planning to understand the market, or in the early stages of divorce or disagreement settlement discussions. (If the settlement discussions escalate to litigation, Sullivan notes the scope may need to be expanded to a conclusion of value.) The calculation of value affords the client and the analyst to select the approaches and methods that best meet the immediate need. For example, if one wants to understand what the market might deliver, the income and market approaches, or just the market approach, could make sense, Sullivan adds. Reporting requirements are not as rigid as they are with the conclusion of value, and the analyst provides a range of value or a single number but is not, technically speaking, opining on the value.

In any event, it’s important to update the business valuation because you never know when a forced exit — due to death, disability, or a partner wanting out — will occur. You then have to scramble and get the business valuated very quickly, cautions Powers. “Business owners should have this valuation updated on an annual basis because we don’t know what’s going to happen in the future,” he notes, “and you want the appropriate valuation at all times.”

Mistake No. 2: Rationing retirement

According to Klein, if there’s one thing advisors stress the most, it’s that valuing the business drives everything that pertains to retirement. “There are other reasons to know the value, but if they are living off the income from this business and this business is no longer there, the income is no longer there because they are transitioning into retirement, so then understand that the value is going to drive that income,” Klein states. “So many business owners who we talk to don’t have a full understanding of how much they are taking from the business because their line item on the PnL [profit-and-loss statement] says they are taking this for an income, but there are so many ancillary things that they are probably doing, as well, and a lot of times they don’t account for that.”

At State Bank of Cross Plains, Chance works in wealth management and spends a lot of time helping people craft their estate plans. In her view, the most important reason to have an accurate picture of asset worth is so that people can create a solid plan that works for them now, at retirement, and at passing. “A business is often the owner’s largest investment by far,” she notes, “so it is crucial to know what the value is in order to make other financial decisions that affect themselves and their family long term.”

(Continued)

 

Mistake No. 3: Assuming virtuous value

In most cases, when an accountant asks how much a business is worth, the conversation tends to center on a number the owner believes he or she would need if they decided to sell, Aime says. “So, it becomes more of this idea that if somebody walked in with a magic checkbook and wrote me a check for $10 million, that’s what I would take and so that’s how I view the value of my business,” he states. “In most situations, that isn’t the case. So, especially when you’re looking at transitioning a business to a key employee or to the next generation, we have to understand what we’ve really got, which is that baseline valuation. Then we can develop planning strategies around that, but first we need to understand what the raw material is.”

Mistake No. 4: Bypassing buy-sell

In MassMutual’s study, only 10 percent of business owners considered a valuation to set the value of their enterprise for the purposes of establishing a buy-sell agreement between partners. That’s probably because it can be unpleasant to contemplate the possibility of an ugly exit when you’re full of optimism about a new enterprise.

“A colleague of mine jokes that buy-sell agreements are like prenups for business partners!” jokes Chance. “A good buy-sell agreement takes into account situations that could threaten the business’ stability — like death, disability, or just wanting out — and makes a plan for how to deal with them and how to fund the buyout of that partner’s interest.”

Aime considers buy-sell agreements to be the most important aspect of valuation. “That’s the key component, and the key component to the buy-sell is number one, if somebody dies or becomes disabled or departs, and there needs to be some kind of buyout, the money has to come from somewhere,” he notes. “The amount of money that needs to be there at that time must be identified. So, when we’re funding buy-sell agreements, without a valuation there is no really effective way to do that. If your business is worth $1 million versus $5 million, the funding mechanism to facilitate that buyout is very different, depending on how many zeroes we’re working with.”

In Sullivan’s view, the buy-sell agreement should be in place right out of the gate, and then it should be reviewed and updated on an annual basis. She notes that some buy-sell agreements stipulate that the owners will agree upon and certify a specific value on an annual basis. “But if, for example, the buy-sell says you have to certify a value annually, but they don’t do it, there is often a backup plan in the buy-sell agreement that says, ‘Okay, now you have to go out and get a market valuation.’ So, they do work very closely hand in hand, and on a regular operating basis getting a business valuation gives the business owners a sanity check as to whether their buy-sell is constructed in a way that still makes sense for them.”

As Chance notes, oftentimes an owner’s business interest is their largest asset, so a lot of their net worth is tied up in the business. Because of this, she says insurance policies often become the best choice to fully fund buy-sell agreements since these policies are able to provide funds at death or disability.

Brinkman agrees, but says it takes some convincing to get clients to buy insurance. “Most of the time it’s the most economical [way to fully fund a buy-sell agreement],” he asserts. “There certainly are people who have misconceptions about insurance and will never buy it, but you have to create the resources to offset an [exit] event like that.”

Mistake No. 5: Doing it yourself

One out of every four business owners say they conducted a formal valuation themselves, but the risk of either undervaluing or overvaluing the business — significantly undervaluing or overvaluing the business — increases with the do-it-yourself method. There are simply too many nuances to consider and a credentialed appraiser can ensure that your succession, retirement, or estate plan isn’t derailed by an unsubstantiated business valuation. The best outside options are a certified public accounting firm or a business valuation firm.

“I don’t think a business owner should ever try to do their own valuation because, frankly, they aren’t objective, first and foremost,” Sullivan states. “We will often see the business owners get caught in what I refer to as the beautiful baby syndrome. They can’t be open and objective about their business. By getting a business valuation done by an independent, credentialed, and qualified business valuation analyst, they are getting the view that a buyer would potentially take of their business, and how the buyer views the business is very different than how the seller views the business.”

The temptation to self-valuate is real, but the figure owners arrive at probably will not be accepted by potential buyers. “They are experts in the businesses they are running, but they are not expert valuators of any business, let alone their own business,” Powers states. “They think they’ve got a handle on it. They might come close, but we would always recommend that they get a third-party valuation. That doesn’t mean they can’t throw in their own two cents but make sure it’s an outside valuation, somebody coming in who does that for a living, because they [owners] can absolutely overprice it.”

According to Aime, when his firm reviews a buy-sell agreement, nine times out of 10 the business owner doesn’t know what it really says. So, if an analyst walks them through the so-called fire drill and explains what happens if calamity strikes (according to provisions of the buy-sell agreement), it’s an eye-opener. “In most cases, that’s not how they see that transpiring, but that is what the buy-sell agreement outlines,” Aime states.

A third-party valuation can not only identify the company’s economic value, but also pinpoint some non-balance sheet issues. Brinkman cited the example of a plumbing group whose sales were increasing when the bottom line was not. Once the top executive determined the value of his business, advisors were able to demonstrate that while he was giving employees a raise and the cost of goods was rising, he really wasn’t increasing his per-hour cost to clients and, frankly, he was afraid to do so. “He said he was so busy, and we said the reason you’re so busy is that you’re probably charging under-market rates, and he was,” Brinkman explains. “So, those are just things that can have an immediate impact on the health of the business and the value of the business that are outside of telling you what the value is.”

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Mistake No. 6: Decoupling personal, business plans

Another overlooked piece of business valuation is understanding the business owner’s personal financial plan and where the business value fits into the overall financial plan. In the 2018 Wisconsin State of Owner Readiness Survey that Honkamp & Krueger sponsored through the Exit Planning Institute Chapter that Sullivan presides over, an alarmingly low percentage of business owners had factored the business into their personal financial plan.

“If a bank asks them to submit a personal financial statement for loan purposes, they will often just put down a value that is several years old, or represents their gut feeling, or things of that nature about what the business is worth, but the fact of the matter is that it’s only paper money,” Sullivan explains. “If they can’t convert that to cash, it doesn’t do them any good in their personal financial plan.”

Factoring the business into the personal financial plan “really helps them understand what their alternatives are in succession,” Sullivan adds. “Without the two data points [personal and business plans], they are kind of flying blind.”

Mistake No. 7: Ignoring multiples

Sullivan, who is also an In Business blogger, writes about the importance of “multiples” in assessing business value. Simply put, multiples are metrics or characteristics that indicate whether the business is well run, and potential buyers will be interested in knowing them.

Examples of the kind of multiples that make a business more attractive to potential buyers are:

  • A fully operational and experienced management team with distributed decision making;
  • A diverse customer base;
  • Documented, state-of-the-art systems and processes with cross-trained employees;
  • Recipes, trademarks, and patents legally protected; and
  • Daily dashboards, including monthly financial statements issued by the third business day, and a clean annual audit.

The multiples that are turn-offs to prospective buyers are as follows:

  • All decisions made by or approved by owner;
  • 60 percent of revenue comes from single customer;
  • Systems are antiquated, no documentation;
  • No legal protection over intellectual property; and
  • Financial reporting backlogged three months with poor quality and accuracy.

“What the multiple represents is the inverse of a discount rate,” Sullivan explains. “The discount rate reflects risk and how much risk is the potential buyer seeing in their investment in this company? If the company is well run, meaning it has a well-functioning management team, the tribal knowledge is documented and can be passed on from person to person, and you’ve got a well-diversified customer base and well-diversified product and supplier bases, it has all the things that drive value in the company. These are also the things that reduce the risk, and the better run the company is, the better the multiple is going to be relative to similar companies in the market at that time.”

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