Understanding Business Valuations SBA America East Conference August 1, 2012 Neal Patel, CBA Reliant Business Valuation Abridged Slides: Email neal@reliantvalue.com for full presentation
Appraiser s Professional Bio Neal Patel, CBA is the Principal of Reliant Business Valuation, a business valuation and equipment appraisal firm specialized in SBA related valuations nationwide. He is a Certified Business Appraiser through the Institute of Business Appraisers (IBA), and frequently trains SBA lenders at regional and national conferences, as well as through live webinars hosted by Coleman Publishing. Neal has extensive experience with small business valuations and financing, and firsthand ownership experience of multiple small businesses. This comprehensive experience helps him understand the intricacies of the businesses he appraises, while enabling him to add unique value to a nationwide roster of clients. Reliant Business Valuation is a leading business valuation and equipment appraisal firm for SBA lenders and currently works with over 75 of the nation s top SBA lenders.
SBA Rules and Requirements The Valuation Process When is a Valuation Required? Business Valuation Basics What if the Appraised Value Is Lower than the Purchase Price? SBA s Definition: Intangible Assets When do Intangible Assets Matter? Fair Market Value and Investment Value Majority or Minority Interest? How is a Business Valued? Asset Approach, Market Approach, and Income Approach Structuring Seller Carry Back Using the Market Approach Valuation Requirement for Refinancing Refinancing Rules Seller s Role-Post Sale Using a Prior Transaction Using the Price/Earnings Multiple Cash Flow Normalizing Adjustments Pop Quiz-Find the SDE Major Screen Out Reasons Which Multiple is Appropriate?
When is a Valuation Required? If the amount being financed (including any 7(a), 504, seller or other financing) minus the appraised value of real estate and/or equipment is greater than $250,000, or.. If there is a close relationship between the buyer and seller (for example, transactions between family members or business partners), or.. If the lender s internal policies and procedures require an independent business valuation from a qualified source.
When is a Valuation Required? The amount of intangible assets or goodwill have NO bearing on whether a business valuation is required. However, intangible assets will have an impact on several other aspects of the loan, as seen in upcoming slides.
What if the Appraised Value is Lower than Purchase Price? A loan can still be processed under delegated authority (PLP). SOP states: Any amount in excess of the business valuation may not be financed with the SBA guaranteed loan. In other words, the appraised value of the business must be greater than the lender s loan amount.
What if the Appraised Value is Lower than Purchase Price? Real Life Example (from a client in this room!): Use of Proceeds Bank Loan Borrower's Equity Total Purchase CRE 580,000 65,000 645,000 Purchase Business 280,000 335,000 615,000 Purchase Inventory - 100,000 100,000 Closing Costs/WC 40,000-40,000 900,000 500,000 1,400,000 If the business valuation equals $500,00 (excluding inventory), can the lender still process under delegated authority (PLP)?
When do Intangibles Matter? SOP 50 10 5(E) States: If the purchase price of the business includes intangible assets (including, but not limited to, goodwill, client/customer lists, patents, copyrights, trademarks and agreements not to compete) in excess of $500,000, the borrower and/or seller must provide an equity injection of at least 25% of the purchase price of the business for the application to be processed under delegated authority.
SBA's Definition: Intangible Assets The value of the intangible assets is determined by either the book value as reflected on the business balance sheet, a separate appraisal for the particular asset, or the value of the business as identified in the business valuation minus the sum of the working capital assets and the fixed assets being purchased.
Intangible Assets: SOP Definition The value of the intangible assets is determined by...the value of the business as identified in the business valuation minus the sum of the working capital assets and the fixed assets being purchased. In other words: intangible assets = business value (working capital + fixed assets)
Let's revisit: When do Intangibles Matter? SOP 50 10 5(E) States: If the purchase price of the business includes intangible assets (including, but not limited to, goodwill, client/customer lists, patents, copyrights, trademarks and agreements not to compete) in excess of $500,000, the borrower and/or seller must provide an equity injection of at least 25% of the purchase price of the business for the application to be processed under delegated authority.
Structuring Seller Carry Back If the combined buyer/seller equity injection is more than 25% of the purchase price, then the seller s note can be bifurcated so that any excess above 25% is on terms not delineated by the SOP. For example, if the borrower is injecting 10% of the purchase price, and the seller is financing 25% of the purchase price, 15% of the seller financing must be on full standby for two years. A separate seller note for 10% of the purchase price can be created with no standby period the terms are up to the buyer and seller to negotiate.
Structuring Seller Carry Back (for a PLP loan) Scenario for acquision financing with over $500M in intangibles: Example 1 Example 2 Purchase Price $1,000,000 $1,000,000 Buyer Equity $100,000 $100,000 Seller Equity $150,000 (full standby) $150,000 (full standby) Total Equity $250,000 25% $250,000 25% Additional Seller Note 0 $100,000 (no standby required) Loan Amount $750,000 $650,000 Seller Note: $150,000 Seller Note: $250,000
Valuations Requirement for Refinancing is the same as Change of Ownership Same as the acquisition rule: If the total amount being refinanced is greater than $250,000 (minus appraised real estate/equipment), then a business valuation of the company being refinanced is required as of the refinance date, not the original purchase date. The original purchase date has no bearing on whether a business valuation is required.
Valuations for Refinance: Today s Date! The valuation should be as of the current refinance date. Example: Jane bought an auto repair shop from her father in 2007 for $400,000 with 100% seller carry back financing (5 year balloon). In 2012, the loan amount is $300,000. The bank and SBA need to know if the business is worth more than the loan amount today, not if Jane overpaid back in 2007 when she purchased the business. If the business is worth $250,000 today, there will be a shortfall in the refinance amount.
Business Valuation when Refinancing Debt SOP does not explicitly state this, but you should request the EQUITY value of the business excluding the debt being refinanced. Include all operating assets in the value (cash, inventory, A/R, etc.), as these will not change after the refinance. Include all operating liabilities in the value (accounts payable, taxes payable, etc.), but do NOT include the debt that will be refinanced. This will provide the lender with the debt free value, so that an accurate Loan to Value can be obtained.
Valuations for Refinancing SOP States: if the amount reflected on the applicant s most recent business financial statements for intangible assets exceeds $500,000 and the applicant does not have at least 25% equity, the application may not be processed using delegated authority and must be sent to the LGPC.
Valuations for Refinancing In this case, the 25% equity is based on the appraised value of the business being refinanced. If the intangible assets on the balance sheet are less than $500,000, the appraised value of the business must be higher than the proposed loan amount, with no minimum equity requirement. Examples on next slide.
Valuations for Refinancing Refinancing a Dentist Practice Example 1 Example 2 Intangible Assets $525,000 (over $500M) $475,000 (under $500M) (on balance sheet) (25% equity req.) Appraised Value $800,000 $800,000 Loan Amount $600,000 75% PLP OKAY $600,000 75% PLP OKAY Loan Amount $700,000 88% LGPC $700,000 88% PLP OKAY The appraised values above are equity values excluding debt being refinanced!
Refinancing Rules Refinancing Seller Financing. The SOP states: The lender may consider refinancing any seller take-back financing with an SBA-guaranteed loan if it has been in place for at least 24 months following the change of ownership and is, and has been, current for the past 24 months. However, if private financing was used to purchase a business, it can be refinanced at any time after the purchase of the business. The private financing cannot be in the name of the business owner, but instead must be in the name of the business.
Save Time, Avoid a Screen Out! Rules you should know! If an unrelated party is purchasing a business, this person must buy all of the existing shares - none of the sellers can maintain an ownership interest in the business. The seller can have a consulting agreement for a maximum period of 12 months after the business is transferred. The seller cannot remain a key employee after this period, nor can he or she receive any form of compensation after this period. Seller earn-outs are not permitted by the SBA. Valuation should be dated within 6 months of loan submission Business Valuation should be USPAP compliant (similar to real estate appraisals)
SBA States the following: Major Screen Out Reasons Failure to include a valid business valuation as part of the SBA application. The SOP States: If the application will be submitted to the LGPC, the business valuation must be submitted as part of the loan application. SBA Express loans fall under the 7(a) program Amount being financed may be less than $250,000, but if there is a close relationship between the buyer/seller, a third party business valuation is still required.
SBA States the following: Major Screen Out Reasons Failing to include allocations of sale in a Purchase and Sale Agreement (PSA). PLP lenders: your loan file is not complete if the PSA is missing allocations! Allocations in the business valuation may be different from the allocations set forth in the PSA or the Loan Use of Proceeds.
Q&A- Topics Discussed Thus Far Business Valuation Requirements. Definition of Intangible Assets. 25% Buyer/Seller Equity Requirement. Valuation Requirements for Refinancing Debt. Seller's Role Post Sale. Major Screen Out Reasons.
SBA Rules and Requirements The Valuation Process When is a Valuation Required? Business Valuation Basics What if the Appraised Value Is Lower than the Purchase Price? SBA s Definition: Intangible Assets When do Intangible Assets Matter? Fair Market Value and Investment Value Majority or Minority Interest? How is a Business Valued? Asset Approach, Market Approach, and Income Approach Structuring Seller Carry Back Using the Market Approach Valuation Requirement for Refinancing Refinancing Rules Seller s Role-Post Sale Using a Prior Transaction Using the Price/Earnings Multiple Cash Flow Normalizing Adjustments Pop Quiz-Find the SDE Major Screen Out Reasons Which Multiple is Appropriate?
Business Valuation Basics Fair Market Value: Standard of Values: Hypothetical, willing/able buyer and sellers, under no compulsion to act, having reasonable knowledge of all facts, acting at arm s length Investment Value: (typically higher than FMV) The value to a particular buyer based on individual investment requirements and potential synergies (intrinsic value)
Fair Market Value vs. Investment Value Fair Market Value Investment Value More conservative approach, values the business as it is currently operating Example: Dry cleaner would be valued based on the current number of employees, sales and expense structure Take into account buyer s synergies and economies of scale Example: Buyer owns 3 dry cleaners in the area, therefore may be able to use existing area manager to replace current manager. May be able to reduce the cost of dry cleaning by closing plan and using one of his other locations. May be able to use one delivery van and reduce auto expenses, etc.
So Which One Do I Use? Fair Market Value vs. Investment Value Currently, it s up to the lender to decide. However, the SBA prefers the more conservative approach (Fair Market Value), as do a majority of our clients. The thought behind using FMV rather than IV is simple: if the buyer feels that there are certain synergies in existence that would warrant an offer higher than the fair market value, than the buyer should pay the difference (between IV and FMV) with his/her own equity injection. This keeps the lender safe, and ensures that the loan is based on the more conservative value.
Majority or Minority Interest? SOP States: A Small Business Applicant may use loan proceeds for a change of ownership in the following circumstances: The Small Business Applicant is purchasing 100% of the ownership interest in a business (either an asset purchase or a stock purchase); or One or more existing owners are purchasing the stock of a selling owner or owners resulting in 100% ownership by the purchasing owners.
Majority Interest for SBA Purposes Elect to value a Majority (100%) Interest for SBA purposes a) The Small Business Applicant is purchasing 100% of the ownership interest in a business (either an asset purchase or a stock purchase) Majority (100%) Interest b) One or more existing owners are purchasing the stock of a selling owner or owners resulting in 100% ownership by the purchasing owners. Although a portion of the business is being purchased, the borrower will end up with 100% interest, so a 100% interest should be valued
How is a Business Valued? Asset approach Market approach Income approach Adjusted Book Value Method (Similar) Transaction Method Single Period Capitalization Method Multi Period Discounted Cash Flow Method *Each approach should be considered in every valuation engagement
Market Approach Compares entity being appraised to comparable privately traded companies or comparable entities which have been recently acquired in arm s-length transactions. Similar to how a real estate appraiser values a house for financing purposes compared your house to similar houses sold, and adjusted the value for extra bedrooms, bathrooms, etc. Adjust market multiples and apply to the subject company. Two main market-based valuation multiples: Price to Sales Price to Earnings
Market Approach Strengths Based on actual transactions. Direct method of valuation if comparable companies can be found. Large pool of data. Relatively easy to obtain data. Weaknesses Are guideline companies truly comparable? Must make sure that data is truly comparable.
Using a Prior Transaction Value of the Company Sold / Earnings = Earnings Multiple Value of Company Sold $ 600,000 Earnings of the Company / $ 200,000 Price / Earnings Multiple 3.0
Using the Market Approach Market Approach is the most frequently used appraisal method for small businesses (sales less than $2 million) Price / Sales multiple Apply a multiple to the sales Earnings $ 200,000 Price / Earnings Multiple 3 Value $ 600,000
Using the Market Approach Market Approach is the most frequently used appraisal method for small businesses (sales less than $2 million) Price / Sales multiple Apply a multiple to the sales Sales $ 1,000,000 Price / Sales Multiple 0.6 Value $ 600,000
Using the Market Approach The Price / Earnings Approach is preferred when calculating the value for financing purposes. The Price / Sales approach does not take into consideration many variable expenses that can impact the cash flow (rent, COGS, salaries, etc.) Earnings streams used: EBIT EBITDA Seller s Discretionary Earnings (SDE)
An Appropriate Multiple Depends on Desired ROI What is the relationship between the Price / Earnings multiple and the Rate of Return (or Return on Investment / ROI)? Price / Earnings multiple of 2.0 2 x Earnings = 2 year payback period = 1/2 or 50% Return on Investment Price / Earnings multiple of 3.0 3 x Earnings = 3 year payback period = 1/3 or 33% Return on Investment Price / Earnings multiple of 4.0 4 x Earnings = 4 year payback period = 1/4 or 25% Return on Investment Price / Earnings multiple of 5.0 5 x Earnings = 5 year payback period = 1/5 or 20% Return on Investment
Using the Price/Earnings Multiple Calculating the different earnings streams Pretax Net Income + Interest EBIT + Depreciation + Amortization EBITDA + Owner's Compensation Seller's Discr. Earnings (SDE or Cash Flow)
Using the Price/Earnings Multiple Normalizing the earnings Seller's Discr. Earnings + Normalizing Adjustments + Normalized SDE or Cash Flow Normalizing Adjustments Non-Recurring Expenses Non-Business Expenses Owner's Perks Rent Adjustment
Cash Flow Normalizing Adjustments Owner(s) compensation (over/under compensated). Related payroll taxes, benefits. Officer s life insurance (if company is beneficiary). Other Discretionary expenses: Profit-sharing plan. Spouse s Compensation (if not involved in business) Health Insurance Expenses Occupancy (i.e. rent expense, lease costs). Moving expenses. Nonrecurring items or events. Non recurring legal fees Non recurring expenses (union to non-union labor, etc.) Unrelated income / pass through income. Transactions with affiliate(s) (i.e. arm s-length).
Which Multiple is Reasonable? Owner s involvement History of business Turnover ratios Liquidity Customer Concentration Contracts Key relationships Size Growth Prospects Profitability Marketability Brand recognition Number of employees Management depth Employee retention Succession plan Reporting systems Comparison ratios Quality of clients Product mix
Which Multiple is Reasonable? Normalized SDE (rounded) 185,000 Chosen Price / Earnings Multiple x 2.0 Estimated Value (rule of thumb) 370,000 2 year return 50% ROI Normalized SDE (rounded) 185,000 Chosen Price / Earnings Multiple x 2.5 Estimated Value (rule of thumb) 462,500 2.5 year return 40% ROI Normalized SDE (rounded) 185,000 Chosen Price / Earnings Multiple x 3.0 3 year return Estimated Value (rule of thumb) 555,000 33% ROI
Other Issues Lender s Should Consider What are quality of the financial statements? Tax Returns, Accountant Compiled/Audited, Internal Financials Are there mistakes on the financials? RED FLAG How many discretionary expenses were added back, and what type of proof was provided? Are there any capital expenditure requirements? (Income approach is only method that factors in cap ex!)
Does 1.25x DSCR Mean Everything is Okay? Previous SDE Calculation with Owner s Draw Reduced + Interest - EBIT 51,201 Estimated Rule of Thumb Value: $416,000 Let s assume purchase price was $600,000 Just because the DSCR is 1.25x, doesn t mean that the business will value out!! + Depreciation 4,425 + Amortization - EBITDA 55,626 + Owner's Compensation 100,000 Seller's Discr. Earnings 155,626 Normalizing Adjustments + Non-Business Auto 8,328 + Owner's Pension Plan 21,487 Normalized SDE 185,441 - Owner's Draw Requirement (100,000) Earnings Available to Service Debt 85,000 Value threshold 600,000 Add: Working Capital 20,000 Add: Closing Costs 20,000 Total cost of business to Buyer 640,000 Cash Down Payment by Buyer 20% 128,000 Amount Financed by Lender 80% 512,000 Seller Financing 0% 0 Projected EBITDA 85,000 Total Proposed P&I Debt Payments 68,211 Debt Service Coverage Ratio 1.25
Final Q&A Fair Market Value Factors and Issues that Impact Value Three Valuation Approaches Investment Considerations Strengths and Weaknesses Typical Adjustments
Questions? Neal Patel, CBA Principal & Founder Reliant Business Valuation 908.248.4658 neal@reliantvalue.com www.reliantvalue.com This presentation is an abridged version. Please email for a full version of the presentation, or to coordinate a time for Mr. Patel to speak with your lenders or conduct a training session.