Book Review

The Art of Business Valuation: Accurately Valuing a Small Business

This is a book review of The Art of Busines Valuation: Accurately Valuing a Small Business. This book is a guide and desk reference for valuing businesses under $10 million in revenues. The primary question answered in the book is: How do we as business valuators, business brokers, accountants, lawyers, owners, and other interested parties prepare, review, evaluate, or use an accurate business valuation for small and very small businesses in a difficult environment? A business valuation is not just a matter of applying techniques, it has to make sense. The business valuation analyst must ask him or herself “Does this make sense?” This is an important question since the financial information provided by business owners is often less than perfect. Furthermore, it is challenging too because often the compilation prepared is based on suspect data.

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The Art of Business Valuation: Accurately Valuing a Small Business

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This is a book review of The Art of Busines Valuation: Accurately Valuing a Small Business. This book is a guide and desk reference for valuing businesses under $10 million in revenues. The primary question answered in the book is: How do we as business valuators, business brokers, accountants, lawyers, owners, and other interested parties prepare, review, evaluate, or use an accurate business valuation for small and very small businesses in a difficult environment? This is an environment where owners are still engaged in planning for the future. The owners are taking out loans. They are adding and eliminating partners who are often lifelong friends or family members, adding to the volatility of the mix. They are getting divorces. Some are even selling or filing for bankruptcy. All of these common activities require an accurate business valuation; this is not just a matter of applying techniques, it requires that the person valuing the business continually ask him or herself “Does this make sense?” This is a hard question since the financial information provided by business owners is often less than perfect. Further, if a compilation has been prepared, it is based on suspected data.

At the heart, a business valuation is a mix of facts and assumption to estimate a value based on future results, as of a given day. Integral to the process is the addition of assumptions—after all, transactional professionals and valuation analyst are looking to the future and layering assumptions. By asking “Does it make sense?”, valuation professionals can build a document and report accurate business valuations even when any one piece of the puzzle does not quite fit. This is one way to master the art of small business valuation.

The target audience of this desk book and reference guide are new valuation analysts, experienced business valuators that may not be familiar with small business market methods, CPAs who serve as analysts or advisors to business owners or buyers, business owners, business brokers, and attorneys with small business owner clients. The desk book is comprised of 15 chapters and provides access to two websites that contain related materials, including calculations, checklists, and sample reports demonstrating the concepts from the book.

Chapter 1—What is My Business Worth?

Value and prices are related but not the same. Price is what someone is willing to pay for the business. Value and valuations are useful for sale and exit planning discussions, but they do not represent prices. This book is about how to value a business and this chapter explores how and why value and price diverge.

Chapter 2—Valuation Basics

This chapter covers the basic business valuation assumptions and methodologies. These are necessary building blocks of every estimate of value. While the chapter delves into the different approaches, standards of value, premises of value, and how a valuation is usually prepared, the author provides a handy checklist of questions to ask. The author observes that “one of the keys to business valuations is asking the right questions. The perfect answer to the wrong question yields an inaccurate result” and these key questions should be reviewed—several times—during the valuation process. The reason is that in his experience “most major errors in business valuation are the result of missing facts or patterns and misrepresenting those facts or patterns, not from misapplication of the model.”

Chapter 3—Why is Valuing Small Businesses Different from Valuing Larger Businesses?

In this chapter, the author discusses the “information gap” on both sides of the model and equation. The author observes that “small and very small businesses are just not very good at data collection, much less providing it to third parties.” The author shares examples and his thoughts on how to value these smaller businesses. Here, again, the valuator must ask “Does this make sense?”

Chapter 4—Assessing the Subject Company

This chapter addresses the information collection and basic analysis of the subject company, whether the engagement involves a conclusion or calculation of value. A key concern here is to assess “according to Eddie Davis: ‘people, process, and profits’”, these constitute the company.

The chapter includes a section on site visits—including preparation—ranking strengths and weaknesses, deal killers, external factors affecting the company value, and financial analysis and limitations of the latter.

This chapter provides insight gained over years; insight not included in the traditional valuation textbooks.

Chapter 5—Normalization of Cash Flows

The question raised here is what cash flow should be used. Should the valuator use EBITDA? Seller’s Discretionary Earnings (SDE)? How are these cash flows adjusted? This chapter discusses what discretionary adjustments to make, sources of compensation, add-backs, the cumulative effect of discretionary add-backs (cash and real estate owned), non-operating and one-time adjustments. The author also concludes the chapter sharing how valuators can and should protect themselves from unauthorized use and users.

Again, the author shares valuable information from years of experience.

Chapter 6—Market Approaches

The challenge here is to apply the properly adjusted cash flows and developing a multiplier from available market data. This chapter builds on the cash flow adjustment chapter and provides guidance selecting the multiplier and use of statistics in the valuation process.

The chapter includes examples on how to develop the multiplier.

Chapter 7—Asset Approaches

The asset approaches look at the value of the assets of the company being valued. This approach is usually used to determine the floor value, which is often considered to be akin to the high liquidation value. The chapter is not a substitute to techniques used valuing machinery and equipment, but it does cover issues presented when built-in gains exist, the problems that arise valuing accounts receivables, intangible assets, goodwill, and liabilities that include personal guarantees.

Chapter 8—Income Approaches

The income approach is the “workhorse of the valuation profession”. In this approach, the estimated cash flow is divided by a capitalization rate in the capitalization of earnings method, or discount rate in the discounted cash flow method to estimate the value. This chapter reviews these two methods and steps used to develop the capitalization and discount rate.

This is one of the lengthier and detailed chapters of the guidebook. The various examples illustrate the complexity and limits associated with the approach here.

Chapter 9—Valuing Partial Interests in a Business

This chapter addresses how to value partial business interests in a business. The chapter includes discussions regarding minority discounts, marketability discounts, premiums, liquidity discounts, qualitative methods, IRS Job Aid Factors, and Mandelbaum-type factors analysis.

The chapter concludes with the author’s view regarding the merits of discounting. Here, there usually is “no perfect or even good data” and the valuator must  arrive at a value that verifies that the “ultimate value found produces a reasonable return for the true risk at hand.”

Chapter 10—Goodwill and the Small Business

The chapter focuses on the various items that constitute goodwill, how to calculate goodwill, and the MUM Method for goodwill. The chapter concludes with insight on how to deal with the personal goodwill of multiple partners.

Chapter 11—Accounting Issues with Small and Very Small Businesses

One of the major differences between larger and smaller businesses is the quality of financial information available to management and valuators. Small businesses, as a rule, have poor quality financial and management information. This chapter discusses the advantages and disadvantages of the cash basis, accrual basis, and tax basis. In addition, the chapter includes a section on estimating working capital, and developing working capital forecasts and capital investment.

Chapter 12—Details for Business Valuators

This chapter discusses topics of relevance to business valuators. They include final selection and weighting of the valuation method, standards related to calculations and conclusions of value, meeting clients’ wishes for multiple purposes, engagement agreements, and more on professional judgment. With respect to the latter, there are many layers of professional judgment and it is almost impossible to consider them all. Here, the author recommends a process for working with professional judgment.

Chapter 13—Assisting the Small Business Buyer or Seller

This chapter addresses working with business owners to prepare them and the business with an exit strategy. The chapter concludes by explaining ways to sell a small business in the market for a price profitably.

Exit planning is a process that takes years. The common problem is avoidance and lack of preparation. One of the issues observed by the author is that there is a reluctance on the part of family members to talk amongst themselves or ascertain the intention of key employees. Professionals also encounter resistance to addressing exit planning.

This chapter includes a discussion on how to ask questions effectively, how to work with business sellers, issues that arise advising owners on creating value, increasing business value, steps for short-term value enhancement, mid-term two- to four-year value enhancement steps, longer-term value creation, issues when representing buyers, buy-sell agreements, and the SBA Lending Process. The author also includes a section on main street business brokerage process, the lower middle market business brokerage process, selecting a business broker, negotiation tips, strengthening the negotiation position of sellers, and due diligence for small and very small businesses.

The above topics also serve to set this book apart from others used in the industry.

Chapter 14—How to Review a Business Valuation

The aim of this chapter is to allow analysts to recognize and overcome biases and for all users to be able to spot errors and problems in their professional reports.

The chapter includes a section of where estimates of value go wrong, cherry picking (or recognizing a bias using an approach or choosing favorable over unfavorable facts or assumptions), selecting the periods for review, and selection of the method, the weighing and other factors. The chapter also includes a “cherry picking analysis form” used by the author to track the overall integrity as the review is performed.

Chapter 15—Final Thought

The author’s parting thoughts are as his father once said, “I would rather be approximately right as opposed to perfectly wrong.” In business valuation, the complex is simple and the simple is complex.

Conclusion

This desk book is distinct from other books written by valuation professionals for training and accreditation purposes. Greg Caruso fills a gap by providing his professional insight on the challenges faced valuing small and very small businesses. This is insight that is not readily available. It has plenty of examples and, despite being 399 pages long, also reads fast. I recommend this desk  reference guide.

Author: Greg Caruso, JD, CPA, CVA, has been involved within the home-building, engineering, and general contracting fields throughout his 30-year career. Over the past 18 years, he has successfully completed over 60 transactions, consulted and advised on acquisitions, exit strategies, and valuations of over 200 firms. He is also Editor in Chief of NACVA’s “Around the Valuation World” and Member of NACVA’s Ethics Oversight Board.

Mr. Caruso can be contacted at (609) 664-7955 or by e-mail to gcaruso@harvestbusiness.com.

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Roberto H Castro, JD, MBA, MST, CVA, is Managing Member of the Law Office of Roberto H Castro, PLLC and Legal Compliance counsel for Equilus Capital Partners, LLC, a closely held REIT. He is also Technical Editor of QuickRead and a member of NACVA’s CUV team.

Mr. Castro can be contacted at (509) 679-3668 or by e-mail torcastro@rcastrolaw.com.