Important Considerations in a Business Appraisal

By: George D. Abraham

CEO & Chief Appraiser

Business Evaluation Systems

The statistics on new business startups have always been dismal with one out of every five surviving after five years.  If you have never started a business, I don't think there are any words to explain the effort it takes to make it successful.  I hear all the time, when deals fall apart, that the Seller was unreasonable. I think a big reason for this is, throughout the negotiations; the seller is constantly feeling like the buyer wants the business handed to him or her on a silver platter and does not appreciate what it took to make the company successful. However, the time between starting the business, the sleepless nights, fear and heroic efforts, until the day it started making a good living for the owner, is the Goodwill created by the owner and is why the buyer is paying for it.  While this is by no means the formal definition of goodwill, it is a good way to think of it. I will give you the formal definition in the latter part of this article.  Therefore, identifying and valuing the goodwill is the single most important consideration in most business appraisals and is why it is imperative in making the following considerations.

Cost of the Appraisal

The old saying, you get what you pay for is more true in business appraisal than anything I know.  There is No Magic Formula.  There is not a set formula to determine the price of a business. Two businesses in the same industry, in the same location, for sale at the same time, may not sell for the same price, based on other intangible factors.  Anyone who has ever sold businesses, or sat on a witness stand, while an opposing attorney questions what aspects of the business you considered in your appraisal, does not really understand the many facets that should be considered in valuing a business.  These factors need to be understood, discussed in the appraisal, measured, assigned a proper risk rating and weighted as to importance in determining the overall value.  Most importantly, the appraiser must determine the appropriate appraisal method for the company to apply these risk factors to.

When you have spent years in building your company, it is imperative, that the appraiser you hire spends the time identifying and considering these aspects of your business in the overall value.  Time is money, and a low cost appraisal is not considering these imperative factors which could cost you thousands or millions in overall value.  There are many appraisers that will tell you that they can do the appraisal for a ridiculously low price but you are going to lose money on the overall value.  This is the equivalent of going to a CPA with just your W-2 showing you made $200,000 and the CPA not considering your expenses. The cost of the preparation of your tax return with this CPA may be very low, but you likely lost a substantial amount of money in taxes. To value a business correctly, an appraiser must spend the time understanding and analyzing all of the factors that make up the value.

Choosing the Right Appraiser

Another crucial consideration is in choosing the right appraiser.  Ask the hard questions; have you appraised my kind of business before and if so, how many?, how would you appraise my business?  You have the right to see what kind of work product the appraiser produces, so ask for a sample appraisal to review.  You may not understand all of the mathematics behind the valuation, but you can see if the appraiser is analyzing the risk factors and how involved he or she is going to be by simply looking at the attention to detail the appraiser puts in the report.

Goodwill

Valuing the Company's goodwill is the most important aspect of the appraisal.  In simple terms, it is the difference between what the business will sell for and the value of the company's fixed assets.  Value is generally determined using future earnings.  Future earnings are what the buyer is essentially paying for. The historical performance of the company does not have much meaning unless it represents what the company will do in the future.  To project future earnings, the appraiser has to understand your business and all of the risk factors in order to do this correctly and most importantly, it must be believable and supportable.  The reader of the report should be able to understand all of the assumptions the appraiser has made, feel they are correct and reasonable, and reach the same conclusion as the appraiser as to the value.  When this happens, the buyer's fears go away and the value of your business is justified.

In the end, the value of a business is not the selling price of the business. The price is determined in the market when a buyer and seller come to an agreement.  As Warren Buffett said, "Price is what you pay; value is what you get." They are not the same.

Cost Segregation Can Maximize Cash Flow

By: George D. Abraham

CEO & Chief Appraiser

Business Evaluation Systems

Although considered a recent concept, Cost Segregation goes back to 1959 from a ruling in Shainberg vs. Commissioner whereby the court ruled on the validity of segregating costs for tax depreciation on buildings and the IRS agreed. Through the years it was tested and more rulings were issued and in 1999, Hospital Corporation of America vs. Commissioner case provided legal support to use Cost Segregation Studies for computing depreciation. Later in that year the IRS Chief Counsel issued further guidance supporting the use of Cost Segregation and in 2004, the IRS outlines the criteria of a quality Cost Segregation Study and provides direction to IRS field agents when reviewing a report.

Cost Segregation allows tax savings from depreciation to be received earlier during a property's holding period which can be valuable because of the time value of money.  Even better, it can provide a large immediate cash flow for currently owned properties acquired in prior years. The present value benefit of Cost Segregation can make a new property viable by increasing its after-tax rate of return.

If you assume something like a large nursing home that is purchased for $3.9 million, dollars, exclusive of land, the tax law allows the building to be depreciated over 39 years using straight line depreciation. A Cost Segregation study identifies assets that may be written off over periods much shorter than 39 years, such as fixtures, built- ins, electrical, plumbing, and land improvements which can be written off over 5 years, 7 years and 15 years.  If you assume that 15% of the $3.9 million cost ($600,000) can be written off in 5 years, and 13% ($500,000) can be written off in 15 years, then the balance of $2.9 million can be written off over 39 years, then the tax savings in the years 1-5 amount to $43,795 per year ($225,128 total depreciation and tax rate of 35%). 

If the property had been purchased 5 years ago, and the Cost Segregation study is performed now, the tax law allows all of the tax savings that could have been received in the years prior to be received almost immediately after the study is completed and implemented for the year 5 tax return.  In this example, $218,975 ($43,795 x 5) cash flow from tax savings is received when the year 5 tax return is filed in year 6.  The cash flow is 5.6% of the cost of the building ($218,975/$3.9 million)

Five and seven year property would be furniture, fixtures, equipment, machinery, computer-related assets, carpeting, decorative finish carpentry, roofing and signage.  Installation expenses for 5 and 7 year property and many types of leasehold improvements, and specialized assets for certain industries such as special doors, electrical connections and circuitry, fire protection systems and HVAC refrigeration units and climate control can also qualify.

Fifteen year property includes land improvements such as grading, drainage, paving, curbs, parking lot, landscaping, fencing, tire stops and billboards.  Added value can even be higher when you consider savings on insurance, reducing real estate taxes on five and seven year assets. In addition to federal taxes, state income tax savings may also be a benefit.

Cost Segregation studies usually take between two to six weeks to complete and are generally economically viable for buildings costing more than $300,000 and having holding periods greater than three years.  Fees for these studies range from $5,000 to $30,000 depending on the complexity and age of the asset.  A quotation along with estimated tax savings are provided free by Cost Segregation firms. Cost Segregation is an effective tool that tax professionals and appraisers can use to add value and cut costs for their clients.