You Had Your Business Appraised, Now What?

You had your business appraised, now what?

By: George D. Abraham

Once the value of your business has been established, the appraisal can stand as a benchmark for improving the value for a later date. From this point on, every dollar that is added to earnings can increase value by $3.00 to $5.00 or maybe more. Now is the time to look closely at the business, keeping in mind some of the positives and negatives the appraiser may have pointed out in the appraisal.

Analyzing Profits and Expenses

Profitability can be increased by either increasing or decreasing revenues, variable costs and fixed costs.

Revenues

Increase in Price of Product or Service: Increasing revenues by increasing price would have to be less than the offset created by the price and resulting profit increases.

Decrease in Price of Product or Service: If decreasing price, revenue would have to increase sufficiently to compensate for the decline in the price. However, if revenues were to increase, as a result of a decline in price, there is a possibility that a decrease in the per-unit fixed and variable costs, due to increased economies of scale, may occur.

Analysis: In analyzing your products, you may find that one has the highest gross margin (GM) and contributes the most to gross profit (GP), but how many units do you have to sell to achieve this? How much of this product inventory must you have tied up to support the sales and what is the rate of stock turn in days? What is your return on investment (ROI)? A simple spreadsheet analysis can help you make the right decisions.

Product	% of Gross Profit	Gross Margin	No. Units	Inventory Turn	Inventory Needed	ROI
A	50 %	$90,000	30,000	344	$85,000	106 %
B	20 %	$50,000	12,000	170	$40,000	125 %
C	22 %	$50,000	17,000	144	$44,000	114 %

Although a substantial benefit will result by decreasing the stock tied up in product A; it does not improve net profit. However, it will definitely increase cash flow and ROI. The increase in cash flow could mean more cash available to promote your business, and thus, an increase in revenues for all products with a consequent improvement in profitability, ROI and cash flow.

A Customer Analysis:

Company owners never forget the customers that contributed to their success and consequently have never increased their price. In general the cost of doing business over the years has gone up significantly and most of these long time customers will understand raising your price, if presented correctly. A simple spreadsheet analysis can help you with these decisions. Below is an example of a Commercial Air Conditioning and Heating Company's analysis.

Customer	% of Gross Profit	Gross Margin	Distance From Ofc. (Mi.)	Average Service Hrs.	Avg. Revenue Per Hour	Cost Per Hour	ROI
A	12 %	$6,500	13	26	$271	$198	137%
B	23 %	$13,000	42	63	$206	$198	104%
C	8 %	$5,000	8	13.5	$370	$198	187%

Customer B, with the highest percent of gross profit has the lowest return on investment and is taking up a significant amount of time which may create a shortage of trucks and servicemen.

Fixed Costs

Costs incurred irrespective of whether or not any sales are made; associated with the physical capacity of the business to provide its service to customers.

Increase: Increase in fixed costs should lead to or be the result of improved product or service quality. If the price of the product is increased to compensate for the increase in fixed cost, the market would have to perceive a higher quality in the product to accept a higher price. If there is no increase in price of the product, the heightened quality would have to attract enough new customers to offset the increase in fixed costs.

There is also the element of increased productivity, time savings and utility reduction that can make the purchase of new equipment feasible. If there is a new, more energy efficient, machine that can cut time, increase output and save electricity, the savings may outweigh the cost.

Decrease: Revenue volume would have to remain unchanged. The decrease in fixed costs could not be allowed to affect product or service quality-which would have a consequential effect on sales. If revenues did decline, the fall in gross profit would have to be less than the decrease in fixed costs.

Variable Costs

Costs that vary directly with sales revenue; in other words, when sales rise or fall, they rise and fall.

Advertising: In analyzing advertising it is not unusual to find that half of the new business is generated by one source. If this is the case, then you can eliminate are decrease those advertising sources that generate the least return and increase the one that is the most profitable. A simple spreadsheet analysis (below) can tell you exactly what is working best for the company.

Source	Cost	Reponses	New Customers	New Revenues	ROI	% of New Revenues
D	$1,800	13	3	$1,800	100%	18.8%
E	$600	22	9	$5,400	900%	56.2%
F	$1,200	6	4	$2,400	200%	25%
Totals	$3,600	41	16	$9,600	12	100%

Labor: Are there employees that will retire in the next couple of years and what would it cost to replace them? If a retiring employee who, after many years of service is making $$60,000 a year can be replaced by an entry level employee at $30,000, would it be advantageous to offer a $15,000 bonus to retire early? First years savings is $15,000 or $75,000 ($60,000 - $30,000 - $15,000 bonus x multiple of 5 x $15,000) in value of the company. The second year adds another $75,000 for a total of $150,000 added to the company's value after 2 years.

Vehicles: Does the company really need those one ton Ford Vans at a cost of $35,000 each with 10 to 13 miles per gallon or can the same service be performed with the new Ford Transit Connect at $23,000 getting 22 to 25 miles per gallon? Many service companies have found that, over the years, the need for the increased size of their trucks have decreased and seldom do they need to haul any large parts. If there are occasions whereby a large part needs to be delivered, one of the large trucks are kept to accommodate this. Again, a simple spreadsheet with the cost of the vehicle, insurance, service costs, tire expense and miles per gallon savings can be very advantageous.

Income Taxes: The game has changed. Throughout the history of the company you have labored trying to minimize taxes. You may have leased equipment and vehicles as it was advantageous because it lowered profits. Keep in mind that we are now looking for more dollars to the bottom line as each dollar now is worth $5.00 more in value. If purchasing equipment or vehicles means you have to pay taxes of 36% by eliminating this expense, you are adding $.64 to the bottom line and that becomes 5 times the amount in value or $3.24. In other words if you are leasing equipment or vehicles for $20,000 per year, by eliminating the expense, you increase your company's value by $64,000 ($12,800 after 36% tax effect x 5 = $64,000).

Further analysis of the expenses the company pays you as a benefit, such as your life insurance premiums, auto expenses, non-essential travel and entertainment, etc., may add more profit to the bottom line and 5 times the amount in value to your company, which may be more beneficial to you.

Shipping Costs: In a recent appraisal assignment we found that instead of raising the price for the company's product, the owner shifted the shipping costs to the customer and gave the customer a 5% reduction in price which eased the pain of an increased cost. It was done with a well written letter explaining the company's increased costs and no customers were lost.

Expand the Company: Maybe it's time to buy a smaller competitor? Who knows, the smaller competitor may be owned by a younger individual that may purchase the whole company when you are ready to retire, and since that person is familiar with the company and perceives little risk (as opposed to an outside buyer) he or she may pay a premium for the company.

In summary, many of these cost saving examples may not work for most companies, but hopefully it can help in analyzing other expenses that may add more dollars to the bottom line.

Valuations for SBA 7(a) Loans

By: George D. Abraham

Unfortunately there are no real definitive guidelines for business appraisals published by the SBA that appraisers can use to understand the psychology involved in the SBA's scrutiny of the appraised values for businesses for 7(a) loan purposes. However after 35 years of appraisals with the SBA, with the exception of the current limit on goodwill financing, the SBA's psychology regarding business appraisal, I feel is very sound and logical.

SBA on Earnings

Again, over the years, I have learned that logic dictates the way the SBA will consider the earnings used in the appraisal. The following are some expenses and SBA's psychology on their being added back to earnings:

Management Compensation

The SBA wants the deduction for management compensation to represent the amount needed to support the buyer's present lifestyle. In other words, if $50,000 is a normal compensation for the owner's duties but the new buyer must have $90,000 to sustain his or her present lifestyle, $90,000 is what the SBA will use.

Contributions and Subscriptions

Every business owner needs to know what is going on in their industry and subscriptions are necessary to keep up with trends and regulations, and yes, a subscription to Powerboat Magazine in the reception area of my Dentist is not discretionary. Also, contributions are usually a form of advertisement in the community and are necessary to a good company image.

Floor Planning Interest

This cannot be added back on many types of companies such as automobile dealerships as it is really considered a normal expense in the cost of the inventory. It is not a note that principle on the loan is being reduced.

Bad Debts that are normal each year

Look at the prior years to determine if the company's bad debts are inherent in the nature of the business.

Medical and Auto Insurance

This is another area to use your logic in. Is this a normal part of a compensation package for this type of company?

Repairs, Maintenance, and Gas for the owner

Again, is this a normal part of a compensation package for this type of company. If the use of the owner's vehicle is required to check on job sites or make sales calls it should not be added back.

Unreasonable amounts for travel and entertainment

Common sense again dictates the decision. A trip to Europe for a Convenience store owner would be reasonable to add back but not the owner of a European Wholesale distributorship.

One-time or non-recurring expenses

Again, use common sense. All companies have regular maintenance and things need to be replaced or remodeled to keep a good public appearance. On the other hand, building costs for more space or legal expenses for the owners divorce would be considered a non-recurring expense

Minor payments for owners home repairs, personal phones and home utilities

These can be considered if the owner has proof they were paid by the business.

Deducting a "Fair Market Rent" when the real estate is owned

Real Estate is usually financed in a separate loan so to establish the value of the business a fair market rent needs to be deducted from earnings. If the company pays rent, then the appraiser needs to make sure it represents fair market.

Other discretionary expenses by the loan officer

Many times the bank's loan officer will have certain expenses that the bank will not allow. There are other expenses that the bank will ask you to eliminate as the new owner will not incur them. One of the expenses is a deduction for management compensation as the new owner already has sufficient management in place to handle the new location and the purchaser's existing business supports him very nicely.

Other Financial Analysis Acceptable

In many cases valuing the company strictly under the definition of Fair Market Value will not yield a value representing the psychology of the deal. For instance, take for example Joe's Transmission shop that has been losing money for the last couple of years and the future looks bleak. Usually the value is going to only represent the assets of the business and the appraised value is $50,000. But let's say that Ernie, who owns 3 AAMCO Transmission franchises, is the buyer and has struck a deal with Joe to buy his shop for $100,000 . Now what Joe did in the past and the outlook for the future has totally changed.

When Ernie changes the name to Ernie's AAMCO #4, his top notch assistant manager for store #3 will be the new manager of store #4 and will have a salary increase of $10,000 but the existing manager of store #4 is no longer needed and eliminates his salary of $32,000. Bookkeeping costs of $6,000 a year are eliminated and advertising for the new store can be added to Ernie's existing advertising which eliminates the $15,000 on Joe's financial statements.

Ernie does provide health insurance to his employees so this will add $17,000 in expenses for store #4. The most significant change is that Joe's cost of goods were running 59% but Ernie's costs from the national supplier are only 30%. This will save the company 29% and equates to a $77,000 reduction in cost of goods.

After adjusting the financials for Joe's shop under Ernie's ownership it is very profitable and the appraised value is now $175,000.

This type of appraisal based on earnings after the purchase is perfectly acceptable to the SBA and again is logical. Also it was a true scenario (names changed) for an appraisal we did last month that SBA approved.

SBA on Assets

Naturally Real Estate is the preferred asset but good fast selling equipment makes them happy also.

Keep in mind that, if the loan package does not include a machinery and equipment appraisal by a qualified appraiser, you must use book value in the appraisal. If the business being sold has intangibles such as licenses, patents customer lists, non-compete agreements, and franchise rights on its balance sheet, the book value can be used for these assets. Intangibles that do not have an existing book value may not be used as an asset.

SBA on Goodwill

The definition of Goodwill by the SBA is;

"Goodwill" is created when an existing business is acquired and the acquiring entity pays more for the business than the book value of the business's assets. Simply put, "goodwill" is the premium the seller is requiring as part of the purchase price (and the buyer is willing to pay) for an established business in the marketplace as compared to that same buyer starting a new business. By paying a premium for an established business, the buyer is relying on the existing business's established market share to continue due to such reasons as an established customer base, a premium location, etc.