Don’t Recycle Business Valuations

Recycle Bottles, Not Valuations

recycle business valuationsValuations are valid only for a specific time and purpose. Typically, a valuator explains the valuation’s scope in an engagement letter and again in the written report. Despite this, business owners sometimes mistakenly think they can save time and money by recycling old valuations for new purposes.

In fact, the unintended use of a valuator’s conclusion can diminish the report’s credibility. It may lead to misinformed business decisions, fiduciary breaches and embarrassing courtroom mishaps.

One wrong turn leads to another

To illustrate the perils of recycled valuations, consider Otto’s Auto Mall, a fictitious private business that reused a valuation three times to save on appraisal fees. Below are the four scenarios under which Otto used the valuation.

Gift scenario 1. Otto initially sought an appraisal when he gifted 10% of the auto mall to his daughter, Olivia, in 2001. The valuator estimated that the fair market value of the business interest was $68,000, including a 15% minority interest (or lack of control) discount and a 20% lack of marketability discount.

Dissenting shareholder scenario. At about the same time, the value of Otto’s Auto Mall was subject to debate in a lawsuit with a 10% minority shareholder.Without disclosing the fact to his valuator, Otto applied the value from the gift tax return to the dissenting shareholder’s interest.

But Otto didn’t understand that a different standard of value-fair value-applied in dissenting shareholder cases in his jurisdiction. Based on relevant legal precedent, his partner’s interest wasn’t subject to valuation discounts. Rather, it should have been valued on a controlling, marketable basis. Unfortunately, because Otto’s recycled report applied an inappropriate standard of value, the judge disregarded it entirely and, instead, relied exclusively on the opposing expert’s analysis.

Divorce scenario. A year later, Otto filed for divorce. To value his largest marital asset-a 90% interest in Otto’s Auto Mall-he turned again to the valuation prepared for gift tax purposes. Otto reviewed the valuator’s analysis and adjusted her conclusion for marketability and control discounts taken on the 10% interest. Accordingly, he conceded during settlement talks that his 90% business interest was worth $900,000.

But Otto failed to consider the issue of goodwill. In his state, personal goodwill is specifically excluded from the marital estate. If a valuator had advised Otto about this issue, he could have argued that elements of personal goodwill existed. For example, over the past 40 years, Otto had fostered relationships with repeat customers, personally guaranteed bank debt and directly managed the service department.

Without Otto’s continued support in these activities the business value would drop substantially. In addition, Otto had historically taken very little salary and had just taken distributions from the business. An appraiser with divorce experience might have helped him avoid the “double dip” by making appropriate compensation adjustments to the business’s income stream.

Again Otto didn’t contact his appraiser before recycling her report. Assuming that the auto mall’s value included $300,000 of goodwill and roughly one-third was directly attributable to Otto’s personal efforts, Otto unwittingly overvalued his 90% interest by approximately $90,000 ($900,000 minus $810,000). Further, he was ordered to pay alimony on the distributions from the business while also paying for the value of these distributions in the business valuation.

Gift scenario 2. The most recent wrongful reuse occurred in 2006 when Otto gifted a 10% interest to his son Oliver. He erroneously assumed that the company’s value hadn’t changed much since 2001 and recycled the original gift tax valuation one more time.

But over the previous five years, the local marketplace had changed dramatically. Urban sprawl had finally reached Otto’s town, bringing in four new dealerships and two national service station franchises. Otto also had retired and relinquished control to Olivia and Oliver, who were still learning the business and building relationships and reputability.

Despite the population growth, adverse risk factors significantly diminished the dealership’s value. The outdated report value stated on the gift tax return substantially overstated the value of Oliver’s 10% interest.

Think twice before recycling

Value is a function not only of the performance of the company, risk and the size of the business interest, but also of the valuation’s purpose and timing, as well as the relevant statutes and legal precedent. As this hypothetical example illustrates, recycled valuations can lead to significant errors.

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5 Common Valuation Myths

business valuation

Business valuation is a complex discipline. Much of its lingo, logic and underlying mathematics can be incomprehensible to those outside the profession, giving rise to many misconceptions. So let’s set the record straight concerning five common valuation myths.


1. Net income and net free cash flow are synonymous.

Net income is an artificial accounting concept that is separate from cash flow. Net income includes a deduction for depreciation expense, which many small businesses base on accelerated tax schedules rather than assets’ useful lives. And net income excludes debt service, financing proceeds, owner distributions, capital expenditures and changes in working capital. Accordingly, net income is a poor substitute for net free cash flow.

For example, consider a fictitious business with obsolete fixed assets. Its equipment is in dire need of repair and replacement, because the owner pays himself excessive distributions in lieu of making regular capital improvements. On the surface, the company may appear more profitable than its competitors because its assets have been fully depreciated and current net income includes no depreciation expense.

Substituting net income for net free cash flow may overvalue this hypothetical business. Net income disregards the company’s need to update equipment and the shareholder’s reluctance to reinvest in future operations, whereas net free cash flow accounts for capital expenditures and working capital requirements. In sum, free cash flow is more inclusive and more relevant to value because it represents the amount of cash available to investors in excess of the current operating needs of a business-the essence of value.

2. Unprofitable companies aren’t worth much.

Historic profits are relevant in business valuation only to the extent that they may help predict future cash flow. For example, startups and high-tech ventures may incur losses until they are up and running. Despite being unprofitable, these businesses often possess value because of their potential to generate future cash flow. Hard assets and internally generated intangibles such as patents and proprietary software also contribute value.

Profit also may be artificially suppressed for tax reasons. For example, some professional service firms intentionally minimize net income for tax purposes through partner bonuses. Cash businesses, such as car washes or restaurants, may underreport cash receipts to evade taxes. Values for these companies are often higher than their reported income would otherwise indicate.

3. If its competitor sold for 1.5 times revenues two years ago, a business should sell similarly today.

Although comparable transactions may seem to provide objective, convenient valuation evidence, a lone transaction doesn’t provide a representative sample. A competitor’s sale might include buyer-specific synergies or unique terms, such as an earnout or employment contract for the seller. Consider, too, the reliability of the informant. Like fish stories, transaction details often become exaggerated.

Take, for example, public companies in the funeral industry. In the late 1990s, they aggressively acquire small funeral homes, driving industry pricing multiples to record highs. Although these roll-ups intended to introduce economies of scale and professional management, the strategy failed and forced many acquirers into bankruptcy or reorganization. Today the industry has largely recovered, and pricing multiples have returned to more realistic levels.

4. Tax status has no impact on value.

In several landmark cases-including Gross v. Commissioner, Wall v. Commissioner, Heck v. Commissioner and Adams v. Commissioner – the Tax Court accepted IRS arguments that S corporations (and other pass-through entities) are worth more than otherwise identical C corporations because of their numerous tax benefits.

The most notable advantage to electing Subchapter S status is exclusion from corporate-level income taxes, including corporate-level capital gains tax after a statutory holding period. And S corporation shareholders may receive tax-free distributions as long as their equity basis in the company remains positive.

When valuing S corporations, valuators must decide on a case-by-case basis whether to apply after-tax discount rates and pricing multiples to either tax-affected or pretax earnings. Factors to consider when making this complicated decision include the valuation’s purpose, relevant case law, the company’s distribution history and whether the business interest possesses elements of control.

5. Business value matters only when it’s time to buy or sell.

This is perhaps the biggest valuation myth of all. In truth, virtually every business could benefit from a regular valuation study. From an operational perspective, many business owners have no idea what their asset is worth. An informal valuation can teach management what drives value and ways to increase short- and long-term cash flow. Furthermore, a valuator can shed light on economic conditions and industry trends. This knowledge can improve operating efficiency and, ultimately, increase sales proceeds when the time comes.

Understanding business value is also an important part of contingency planning for key person life insurance, buy-sell agreements and succession plans.

One universal truth

If you’re confused about business valuation, you’re not alone-its ins and outs are frequently misunderstood. An experienced valuation professional can help clear up any myths and ensure your company is accurately appraised.

JoAnn Lombardi | Valuation When Buying or Selling a Business

Valuation Considerations When Buying or Selling a Business

By JoAnn Lombardi, President of VR Business Brokers

The single most important decision in making an acquisition (or completing a merger) is in determining the value or setting the price.


There are many considerations that should be made when estimating the value of a mid-market business. The most important are:
  • Stability of historical earnings,
  • Future projections,
  • Verification of information,
  • The actual assets included in the sale.

Read more here Valuation Considerations When Buying or Selling a Business


For assistance in valuing a business one of our professional Intermediaries can be reached through VR Business Brokers at 1.800.377.8722

Business Valuation Article – VR Business Brokers

Setting the Record Straight on Business Valuation

Many people can become incredibly confused about understanding what business valuation means. Many misnomers exist regarding the subject, which can be a complex financial discipline that consists of unintelligible jargon, reason and underlying mathematics to any outsider who may be looking to buy or sell.

Therefore, let’s reveal the truth behind a few myths of business valuation.

1.) Net income and net free cash flow are identical

First of all, there is nothing remotely similar to these two concepts. Net income includes a deduction for depreciation expense that many small businesses base on accelerated tax schedules. In addition, net income excludes debt service, financing proceeds, owner distributions, capital expenditures and changes in working capital.

Net free cash flow is more inclusive and relevant to value because it represents the amount of cash available to investors (equity and debt holders) in excess of the current operating needs of a business – the essence of value.

Therefore, a novice who substitutes net income for net free cash flow risks overvaluing the business because the former may disregard a company’s imminent need to update such things as equipment and the shareholder’s reluctance to reinvest in future operations. Net free cash flow takes into account capital expenditures and working capital requirements.

2.) Unprofitable companies have no value

Remember that fledgling businesses will possess value because they have potential to generate future cash flow, hard assets and internally generated intangibles such as patents, customer lists and proprietary software. Just because historically there may have not been profits in the past doesn’t mean there’s no value in a company that you may be looking to buy. For instance, startups and high-tech ventures my incur losses until they are up and running.

3.) If a competitor sold for 1.5 times revenues two years ago, a comparable business could do the same for a similar price-to-revenues multiple today

Nothing could be further from the truth in this instance. You may think comparable transactions provide objective, convenient evidence; but one, single transaction doesn’t provide a representative sample.

Remember that each transaction is unique. For example, a competitor’s sale might include buyer-specific collaboration like an earn-out or a seller’s employment contract. Ask yourself if the informant is reliable. Like an old wives tale, transaction details can become exaggerated and evolve over time as the story passes from one individual to another.

4.) Business value only matters when considering buying or selling

The granddaddy of all valuation myths, every business can benefit from studying the subject regularly, not once in a full moon.

Most owners have no clue what their business is worth from just an operational perspective. Therefore, having an informal valuation can teach management what drives value and show how to increase cash flow for both the short and long terms.

A valuation can shed light on economic conditions and industry trends that can help you improve operating efficiency and increase sales inevitably. It can be an integral part of contingency planning that can help management assess the adequacy of commercial and key person life insurance coverage as well as serve as an underpinning of effective buy-sell agreements, succession plans and individual wealth management planning.

— Peter King; CEO, VR Business Brokers

 For assistance with Business Valuation please contact VR Business Brokers at 1-800-377-8722