CFO

Do You Know What Goodwill Is?

I have a client who was discussing the value of her business with a family member. The family member asked her why there was no Goodwill on her balance sheet – that surely her business value would be higher if she were to include that. She posed that question to me and in the following discussion I came to realize that for many people outside of the accounting world, the idea of Goodwill, where it comes from and how to include it on your financial reports, is not very clear.

What is Goodwill?

Investopedia: Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill.

Wikipedia: Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business. Goodwill represents assets that are not separately identifiable. Goodwill does not include identifiable assets that are capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability regardless of whether the entity intends to do so. Goodwill also does not include contractual or other legal rights regardless of whether those are transferable or separable from the entity or other rights and obligations. The goodwill amounts to the excess of the “purchase consideration” (the money paid to purchase the asset or business) over the total value of the assets and liabilities. It is classified as an intangible asset on the balance sheet, since it can neither be seen nor touched.

What is an intangible asset – and what other kinds of assets are there?

Intangible assets are those that are non-physical, but identifiable. You can describe it and it is real, but you can’t pick it up and move it to another room. Most assets are tangible – meaning they are physical assets, things you can touch. Tangible assets include cash, office furniture, production assets (for manufacturing, like mixers, bagging equipment, tractors), and things like money that other people owe your business – loans you have made or trade receivables – money your customers owe you.

Goodwill is not the same as other intangible assets. Goodwill is a premium paid over fair value during a transaction and cannot be bought or sold independently. Other intangible assets include things like patents and licenses and can be bought or sold independently.

There are accounting rules related to the ongoing treatment of goodwill on your balance sheet – impairment – amortization – but that is not what this article is about – you can learn the correct accounting treatment when you get to the point of recording goodwill on your balance sheet. This article is intended to help business owners understand how they create goodwill, what it is and why they may not actually be able to “see” it in the financial reports.

When does goodwill show up on a balance sheet (and when does it not)?

Goodwill only appears on your balance sheet if you buy it, by buying an existing business. For all of you who have started a business and built it into a successful company with employees, returning and loyal customers, products and services – your company most likely has goodwill, but your financial reports will never include it. You won’t know until you sell your business just how much goodwill you have built.

Goodwill is essentially the difference between the value of your business as an operating company and the value of the tangible assets your business owns. I’ll use my client’s business as an example. As a service business, she does not have a lot of tangible assets – there is no inventory. Her customers owe her money (Accounts Receivable), and she has a bunch of laptops and desks. That’s about all that is in the asset section of her balance sheet – not worth much. But if she were to sell her business, she would never sell for the value of her assets – her business has a strong reputation and is a leader in her industry. Her business has an extensive client list – many of which have been clients for years. The business has many very experienced employees who also perform services for her clients. The business has a method of serving clients that is unique within the industry. All of this added together is Goodwill.

If she were to sell her business (it’s not for sale), the buyer would have goodwill on the balance sheet.

Is goodwill the same thing as blue sky?

These terms are similar but are not really identical. Both represent unrealized value in a business. The term blue sky is often used to describe a larger unknown future value – some business professionals tend to consider blue sky to be the same as pie in the sky – something that is very unlikely to be realized. Goodwill is a standard accounting term that the industry has accepted to fill the gap between a purchase price of a business and the tangible asset value. “Blue sky” is an informal term that means, according to Merriam-Webster, “having little or no value” and “not grounded in the realities of the present.” Blue sky is what business owners hope will be realized, goodwill represents what they have built through hard work, planning, and successful execution.

What creates goodwill?

Goodwill is created by running a successful business. Customer loyalty, brand reputation, and other non-quantifiable assets count as goodwill. A company’s record of innovation and research and development and the experience of its management team can also be goodwill. Other examples of goodwill include; value that has been built up within a company as a result of delivering amazing customer service, unique management, the company’s reputation, size and loyalty of the customer base, number of years in business, market penetration and brand awareness, or any intangible situation in a business which gives the business some competitive advantage. Goodwill is not necessarily specific and identifiable but is the accumulation of successfully running a competitive and viable business.

Why you want goodwill – even if it is invisible.

As a business owner, the knowledge that you are building goodwill is the knowledge that your business will be worth money to someone in the future, you intentionally develop aspects of your business that will be valuable to a new owner – aspects of your business that are worth money even without your participation. The amount of goodwill that you build will not be something you can measure by putting it on your balance sheet as you build it – it won’t be measured or even fully evident until the day you sell your business.

Not all goodwill adds value to your business. There is such a thing as personal goodwill that does not have external value. As a business owner, you probably have personal goodwill as well as business goodwill – or you may only have personal goodwill. Personal (or professional) goodwill is linked to individual business owners and their abilities to generate future income. It often attaches to a professional person because of confidence in that person’s skills and credentials.

An example of personal goodwill is my own consulting practice. My business (by design) is not structured to have any value outside of my own personal goodwill. I have not created a business that has value to a third party – at least not now.

Contrast that to my client that has a business that does have business goodwill. She has intentionally built a company that will have value to another person. No doubt she also has personal goodwill, but she can be separated from her business and the business will provide value to a new owner.

Whether you have goodwill on your balance sheet due to a business acquisition, or you don’t have goodwill on your balance sheet, it is important for your business value (and your financial future) to build goodwill. Create a business that is valuable without your direct participation. How that looks for your business may be different than how it looks for someone else’s business, but it is important none the less. Create a business plan that will develop goodwill – a business that has value beyond the value of your tangible business assets – in order to create a company that someone else can benefit from owning.

To explore related topics of building business value, visit terrylpetersoncfo.com and click the “articles” tab.

And how do you know if you have a good one?

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Finding and Keeping the Right Bookkeeper – what you need and how to find it

Why is it important?

For business owners it is important to know that your financial records are being accurately maintained.  Not all bookkeepers have equal skills.  Some are much better than others and it may be difficult for you to know the difference.

I’ve witnessed many situations in which a business owner has had to spend thousands of dollars to clean up after a sloppy bookkeeper, has had trouble getting a loan, or has been in trouble with vendors.  I won’t go into detail here, but it is heartbreaking to witness the stress and anxiety of the business owner who trusted the bookkeeper.

The old adage of “you get what you pay for” holds true with services like this too.  Take the long view on saving money – invest in current expenses to save money in the long term.  Hourly rates will vary depending on where you are seeking a bookkeeper.  The rates I am using are for a small town and are likely lower than any major metropolitan area.

What makes a bookkeeper qualified?

Bookkeepers gain qualifications the same way everyone does – through education and experience.  Some people have a knack for figuring things out and make good bookkeepers because of a natural tendency to pay attention to details and to solve problems.  This alone will not result in a bookkeeper who understands why they are doing what they are doing.  It only means that they don’t make errors in the stuff they are able to do.  But throw them something new and they may not know what to do with it.  Or ask them a business analysis question and they may not know where to start looking.

Education can happen on the job, working with a more experienced accountant, or in a more formal environment like a trade school or community college, or a four-year college.    Ask your potential bookkeeper how they learned their trade and how long they have been doing it.

What levels of qualification are there?

And what each one will get you and how much you should expect to pay $$

QuickBooks Certification:

• QuickBooks offers several different certifications.  Some certifications are specific to versions of their software (desktop, online, or enterprise) and some are related to providing higher-level software use advice to others (ProAdvisor)
• The certifications are generally focused on the individual’s knowledge of using QuickBooks software more than accounting knowledge.
• Useful if you use the same version of the software the bookkeeper is certified for
• Not necessarily an indicator of ability to problem solve or understand the principals behind “why it is done a certain way”

May be a good fit if partnered with a more experienced resource to oversee day to day.  If they are working closely with a career accountant with a degree or a CPA, they can be a good, inexpensive resource. Going rates will vary by geography – locally under $50 per hour.

No certification: 

• Can record regular, routine transactions correctly if they are trained by someone who knows the correct method
• Not necessarily able to problem solve and record a transaction that is not routine
• Can produce standard reports out of your accounting system but is not generally able to tell you what they mean.

If your resource is in this category, be sure that they have experience and you have a way to assess their skills.  If they are working closely with a career accountant with a degree or a CPA, they can be a good, inexpensive resource.  Going rates will vary by geography – locally under $40 per hour.

Trade school/Associate’s degree: 

• Some basic understanding of accounting concepts and how to manage a set of books. 
• With some guidance they can handle your basic transactions but may not be able to correctly manage more complex transactions or provide any analysis. 
• Can identify problems but may not know what to do to correct them – from a correct accounting perspective.
• Can produce financial statements and generally understand what they are seeing

An excellent resource if you have a strong relationship with a higher level professional (CPA) who can provide some guidance when needed.  Going rates will vary by geography – locally $40-$60 per hour.

Bachelor’s degree: 

• A degree in accounting or other business subject that includes some level of accounting.  A degree gives the holder a theoretical understanding of the accounting profession
• Able to correctly handle any accounting transaction
• Can provide financial analysis when needed
• Can produce and interpret financial statements

An excellent resource who can handle your day to day accounting needs and may or may not be able to assist with budgeting and building financial projections.  Going rates will vary by geography – locally up to $75 per hour.

Certified Public Accountant (CPA): 

There are a number of bookkeepers who are Certified Public Accountants.  A CPA is fully qualified to handle any accounting challenge you may have.  To gain this certification an individual must have 4-year degree and a certain number of hours of experience as well as passing a very rigorous exam.  You are in good hands with a professional at this level.  Going rates will vary by geography – locally up to $120 per hour.

What level of qualification is right for you?

There is no “one size fits all” answer.  Variables that you need to consider are:

• What is your knowledge/comfort level with the world of accounting?
• Will your bookkeeper be working independently or with guidance from a higher-level accounting professional?
• How big and complex is your business?

As a business owner, how can you assess the skills of a potential (or current) bookkeeper?

Unless you have knowledge and experience in the accounting profession it may be difficult for you.  Once you understand what the right fit is for you from the examples above, here are some guidelines to determining what each individual is capable of.

• References – always ask for and check references.  Look for current and former bookkeeping clients.  Ask about accuracy, time spent per month, and ability to answer questions from the business owner.
• Find out what CPAs the bookkeeper has worked with (usually providing client year-end financials) and ask the CPA for impressions of the skills of the bookkeeper.
• What education does the bookkeeper have?  What degree and what field of study?
• Find out how and when they became a bookkeeper.  What did they do prior to that?
• Ask what personal habits they have developed to double-check their own work
• Ask specific accounting questions
  • Accrual vs cash – do they know and understand the difference?  Can they explain it to you?
  • Do they regularly use any reports (AR, AP, Inventory) when they are working?  What do they use them for?
  • Give them a sample Profit & Loss Statement and ask them to tell you if the business is doing well or not.
  • Give them a sample Balance Sheet and ask them to explain to you what it means.
  • What reports do they recommend a business owner look at each month?

If you need help in selecting a bookkeeper, ask your CPA or banker to connect you with someone skilled enough to support you in assessing your candidates.  If your bookkeeper will be working independently (most are) it is critical that they have excellent problem-solving skills and are not afraid to ask questions.  This is an important professional relationship – setting it up for success for you and your business requires you to assess your needs carefully and select the best fit.  Spending money on the front end to get the best resource will pay off quickly in reduced tax preparation costs and your peace of mind for always knowing the financial status of your business.

Now what do you do?

You’ve spent years building your business to be financially successful and personally fulfilling. Now that you have achieved that, what happens next? How long do you plan to continue to work? Who will take over your business when you no longer want to be involved every day?

If you don’t have answers to these questions, it’s time to engage your thought process and your best and most trusted advisors to develop the answers.

None of us will work in our business forever – we’ll exit either by closing the doors and walking away, by selling or transitioning to a new owner, or because we pass away. Choose your preferred method of being done with your business and plan accordingly.

It can be okay to just close the doors and walk away – maybe your business plan has been just to provide yourself with a job – that’s legitimate. You should still consider what may happen to your customers and employees should you exit “unexpectedly.”

Most business owners have a vague thought that they will eventually sell their business – maybe for enough to fund a decent retirement – maybe to a family member or key employee. All of these are good ideas, but ideas are not the same as plans. Talk your ideas through with a trusted advisor like your CPA or lawyer. If your idea involves family members or key employees, talk it through with them to be sure their vision is lined up with yours.

As your ideas progress into plans, document your plan to be very clear about what you intend to do, and when.

According to Wikipedia:

• An exit strategy is a means of leaving one’s current situation, either after a predetermined objective has been achieved, or as a strategy to mitigate failure. An organization or individual without an exit strategy may be in a quagmire. At worst, an exit strategy will save face; at best, an exit strategy will peg a withdrawal to the achievement of an objective worth more than the cost of continued involvement
• In business, an exit strategy is a way to transition one’s ownership of a company or the operation of some part of the company. Entrepreneurs and investors devise ways of recouping the capital they have invested in a company. The most common strategy is the sale of equity to someone else.

The key word is “PLAN.” To accomplish your goals, you need to make things happen, not just let things happen. Up to 35 % of business owners say they will never sell their business. That’s fine, but it’s still important to plan for your customers, partners, and employees to be prepared for the eventual outcome.

The other 65 % of business owners do think they will sell their businesses. If you are in this majority, there are several things that you should consider as you develop your plan. These include:

• Your future role in the business – do you want a phased exit?
• Your liquidity needs – when do you need the cash and how much?
• Your company’s future potential – a strong business can easily outlast the founder
• Current market conditions that may impact timing and value – consider exiting when your industry is “hot”

Keep in mind that it can easily take five years to prepare a business for sale – to get the price that you want to get. Don’t put your business on the market until you have reason to believe that the price tag will meet your needs – do your homework and get the advice of a professional as you go through this process. Business owners can take actions while they are running the business that will result in a higher value on the sale date. Start early to maximize this value.

How do you build value in your business?

• Build a business that is not dependent on you. Can your business run without you for weeks at a time? Do you have a team in place to handle all of the operations of the business? Consider that a buyer taking over your business may not have the expertise you have in your industry – make it a turnkey operation for your buyer.
• Business processes that are repeatable and not dependent on a particular person to be done correctly. The process itself needs to be clear so that any capable and qualified person can successfully follow the process.
• Business systems that function smoothly – avoid systems that only you can understand. Get your accounting system, customer management system, and all business operating systems running so that any trained person can run them.
• Evidence of compliance with all requirements (tax, legal, environmental, etc.) Definitive documentation will reduce the unknown liabilities related to your business – an attractive feature for any buyer.
• Full separation of business and personal finances. To assess the results of business operations, it is important that your personal expenses are not included in the P&L. Make a practice of paying those expenses personally so that your business P&L reflects only expenses related to your business.
• Retain equity (cash & assets) in the business. The strength of your balance sheet is as important as the strength of your P&L. Maintain a clean balance sheet with all accounts reconciled and pay attention to your liquidity and working capital ratios.

As you begin to make decisions about the future of you and your business, document what you want. You can start with writing it all down, then proceed to talking with others who may be involved in your plan, then work with your tax and legal advisors to make your plan into a reality.

It’s not really a plan if it’s just in your head. Engage your advisors and put things in place to ensure that your plan will become a reality. Write it down, talk to others, update your plan regularly, and your exit plan will become integrated with your business plan.

Why is Business Valuation Something You Need to Think About?

What is your business worth?  How is it valued?  Whether you are thinking of buying a business, selling a business, or planning ahead to sell your business at a future point, knowing what the business is worth is an important first step.

The value of a business is defined as “the price at which the business would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or to sell and both having reasonable knowledge of all relevant facts.”  There is no one formula to get there – the value of any business, including yours, or the one you want to buy, is very complex.  The answer to the question “What is my business worth?” has one easy answer – “It depends.”  There are as many factors involved in establishing the value of a business as there are reasons to know the value of the business.

Understanding the components that create value in your business can provide you with a framework to increase the value of your business.  As an owner, you can use a business valuation as part of your business planning strategy to establish and track goals for your company and to determine the timing of your exit.  Your exit might be retirement, or it might be bringing in additional owners that will eventually buy you out completely.

For most business owners, the most important asset they own is their business, but it is the hardest one to place a value on.  Investment accounts, real estate, and other assets are relatively easy to value.  Business owners may spend a lifetime building their business and working in their business, but have no clear understanding of what it is worth.  For many, they imagine it is worth whatever they believe they need to retire comfortably.  Reality is often disappointingly less.  The sooner an owner understands how a buyer will determine value, the longer the timeframe they have to improve that value and realize success for their years of hard work.

For some business owners, and exit strategy may be bringing in additional owners as the business grows.  This can allow for continuity of a business beyond the founder.  This is a common practice among professional services companies – accounting, legal, and medical practices – but the concept can be applied in many types of organizations.  To successfully set up an ownership structure like this, the business needs to be valued and a method to measure value regularly needs to be established.  This can allow ownership to expand and contract over time with ease, and can allow the founder to fully exit when they and the business are ready.

Gaining an understanding of what makes a business valuable to a buyer will help the business owner stay focused on the aspects of their operations that make the most difference in the long term outcomes.  Planning on a business sale well before the time they want to sell will enable an owner to get the highest possible value for their business and consider the type of buyer who will place the highest value on their company.

From the buyer’s perspective, knowing how a business is valued will bring you closer to paying “the right price” for an acquisition, not overpaying – so you can see the returns you desire from the acquisition.  The asking price and the purchase price are most often not often the same thing.  Know that going in and be prepared to negotiate a fair price.  Many small business owners have strong emotional attachments to their businesses and tend to consider all their hard work as part of the value.  Buyers need to understand that as they work toward completion of an acquisition.

Business valuation is at least partly an art – there is no “one right way” to do it, but there are many sound approaches that have been established over time and through years of practice by valuation professionals.  How your business is valued will depend on the size, industry, financial history, and the current marketplace.  While there are some “rules of thumb” that can be used to provide a proxy for the value, a complete and professional valuation considers a multitude of factors and comparisons as well as the professional judgment and experience of the individual performing the valuation.  A valuation professional has access to multiple sources of data to analyze and compare your business to other similar businesses.  They will combine data, analysis, and experience to determine the value of the business.

There are many reasons to have a professional valuation completed on your business, and doing it sooner rather than later can help you plan for the future.  While planning will never eliminate risk from business ownership, it will reduce risk, and improve your chances of business and financial success.

Think of all the possible reasons to have your business valued.  Which ones are most relevant to you?

Don’t forget any of the details! The end of the year brings extra work for your business’ financial team. The additional year end requirements of wrapping up one year and starting the next can be overwhelming. This checklist will help keep you on track through this very busy time of year.

1. Do you have the books for the prior year wrapped up? Do you need to consider changes in accounting practices to correctly reflect changes in your business processes?
2. Have you recorded depreciation and amortization for the year? Have you recorded all your fixed asset additions and deletions for the year?
3. Have you recorded anticipated income tax liabilities for Federal and all States you will need to pay taxes in?
4. Have you reviewed your income statement and balance sheet to be sure that all account balances are correct? Do the final account balances “make sense?” The end of a year offers an opportunity to “clean up” your records. Are there account balances that have not changed all year? Should they have changed? Are there transactions that were recorded to the wrong account and they have been sitting all year waiting to be corrected? This is an excellent time to do that.
5. Are all your Prepaid Expense accounts up to date? Did you expense the correct amount for the current year and have an asset remaining of the correct amount for the future year?
6. Do you need to accrue a liability for any expenses that were incurred, but not yet billed to you or paid by you?
7. Do balance sheet accounts balance to detail for Accounts Receivable and Accounts Payable? Are there bad debts that need to be written off? Old balances that need to be cleared up? Is your bad debt allowance account a reasonable amount for the level of bad debt you have experienced?
8. Have you completed a physical inventory? Did you adjust your books to reflect current inventory? This should include write-downs of obsolete inventory.
9. Do you have your financial reports in place to meet the needs of your creditors and investors as well as your internal needs?
10. Do your financials need to be reviewed or audited by a CPA to comply with your financing covenants? Have you scheduled that work? Do you have internal resources to support the work?
11. Have you identified your tax preparation schedule for prior year taxes and have a resource that can provide the necessary information to your tax preparer?
12. Have you planned for reporting and payment of payroll taxes including W-2 preparation and distribution?
13. Do you need to prepare and distribute 1099 forms?
14. Is your budget for the coming year complete? Does it align with your overall business strategy? Have you entered your budget into your accounting software? Did you prepare a cash flow budget for the coming year?
15. Do you have reporting in place to determine if your actual results are matching your budget for the coming year?
16. Do you understand your cash flow needs for the coming year and do you have financing in place to meet those needs?
     

The logistics of getting started

When you get ready to start a new business there are many tactical details necessary to get the business set up and formed. Many of these are easy things to do, but require time, effort, and information. I hope that the following list will help you find the resources you need and ensure that you complete the process easily so you can focus on the business of your business.

Decide what type of business entity will best meet your needs.  For information on what these different business types are, go to http://en.wikipedia.org/wiki/Types_of_business_entity#United_States to learn about each type of entity.  This link also includes naming requirements by state.

You will need some professional assistance to support the start up and operations of your business.  Locating both a CPA/tax preparer and legal advice should be done early in the process.  Get referrals in your local area from friends and business associates.  You can also get listings from state associations. http://www.taxsites.com/cpa-societies.html lists state CPA societies so you can identify professionals in your area.  For legal resources, this link will help you find local bar associations http://www.abanet.org/barserv/stlobar.html.  Getting good advice on the start up of your business will help prevent problems from coming up later.

Unless you are a sole proprietor of a single member LLC with no employees, you will need to have a Federal Tax Identification Number (FEIN), the business equivalent of a social security number.  To apply for a FEIN, go to http://www.gov-tax.com/?rdir=1268257787&sc=0.

After you select a business entity and get a FEIN, you will need to register your business with the Secretary of State in the State in which you reside.  Use this link to locate the Secretary of State that you need to register with.  http://www.secstates.com/?gclid=CLr_wbiWr6ACFRsVawodSQxVZQ

Each city and county may also have requirements for licensing your business.  Many websites have the forms and requirements online.  It is important to check with your local jurisdictions to be sure that you are correctly registered. 

Sales and use taxes may also apply to your business.  This can also be determined by your local jurisdiction resources and state department of revenue resources.  By using the link http://www.irs.gov/taxpros/article/0,,id=100236,00.html you can find your state department of revenue.  You will also need to locate your county and city sites.

 It is best to set up a separate bank account from the very beginning of your business to maintain clear lines between your personal finances and your business finances.  Visit your personal bank to learn about what they can offer you.  If you have a strong relationship at your current bank that is a good place to start, but it is a good idea to see what other banks can offer as well.  As your business grows, you will need additional services to support it so be sure that your bank will meet your needs not only today, but in 2-3 years.  As your business becomes more established, changing banks will become more complex.

Recordkeeping for your new business is critical.  It is best to start detailed recordkeeping from the beginning.  You can work with a bookkeeper, or purchase your own software and do it yourself with a little bit of support to get set up.  There are business that focus on setting up your bookkeeping and “coaching” you to do it yourself, or working with one of your employees to do it yourself.

Physical location may also be important for your business.  Do you need to have a street view or is less expensive rent more important.  Be sure to select a location that matches the type of business you will be opening.  Check with your city and county to be sure that you are in compliance with all zoning regulations for your area.

Furniture and equipment may seem easy, but it needs to be appropriate to your business, your space, and the needs of your business for the first 6-12 months of operation.  Be sure to keep your receipts so you can record these purchases as business assets.

If you plan to have employees, or to pay yourself as an employee, it is helpful to locate a payroll service.  These services are familiar with payroll tax requirements at the federal and state level and will submit payments directly to the required jurisdictions.  They will also handle year end reporting to federal and state agencies.   There are local, regional, and national services available.  To locate a service, you can use this linkhttp://www.justclicklocal.com/citydir/Denver-CO–Payroll-Service.html, or talk to friends and business associates to get referrals.

Buyer Beware – and Become Informed

A Buyer’s Guide to Business Valuation

You have often heard the term “let the buyer beware.” This statement summarizes the concept that a purchaser must examine, judge, and test a product considered for purchase himself or herself rather than relying on the seller to represent the product.

If you are considering buying a business, it is important to gain an understanding of the value of the business. Part of the process is realizing that the seller of the business has a very different goal that you do as the buyer. The seller may have engaged a business broker to assist in the sale of the business. The business broker acts on behalf of the seller to identify a buyer and bring the buyer and seller together. Business brokers often provide the seller a business valuation as part of the service they are providing. Business brokers work on a commission basis – earning a percentage of the sales price for the transaction. The broker is working for the seller and is not an independent third party to the transaction.

Also consider that any time you purchase real estate (that requires financing), the bank requires a property appraisal. This is true for both commercial and residential real estate. When you purchase a business that does not include real estate, it is unlikely that a loan will be based on the business you are acquiring. More likely it will be based on your personal assets – mainly the equity in your home. Since the banks don’t ask for an independent appraisal on the value of the business you are about to purchase, there is no requirement that you have someone assess what that business is worth. You are free to overpay as long as you have the personal assets to reduce the bankers’ risk.

How can you gain some assurance that you are not overpaying for a business?

As a buyer, you need to have objective information to reduce the risk that you do not overpay for your business. Consider an independent valuation for the business.

Independent business valuations can be performed by a wide range of professionals. There are various certifications including:

• American Society of Appraisers (ASA): Accredited Senior Appraiser (ASA)
• CFA Institute (CFAI): Chartered Financial Analyst (CFA)
• Institute of Business Appraisers (IBA): Certified Business Appraiser (CBA)
• American Institute of Certified Public Accountants (AICPA): Accredited In Business Valuation (ABV)
• National Association of Certified Valuation Analysts (NACVA): Certified Valuation Analyst (CVA)

All of these certifications require experience, coursework, an exam, and a case study to gain the credential and can provide you with an independent opinion as to the value of the business. An independent valuation may align with the valuation of the broker, but not necessarily.

Regardless of the source of the valuation, it is important that you are able to assess the likely cash flows from the business. As part of your due diligence in the purchase process, request at least five years of financial data including profit and loss statements and balance sheets. Build your own projection of future cash flow to gain an understanding of the ability of the business to generate cash for you. Can you earn a return on your investment? Can you pay off any debt associated with the purchase? It is not just the purchase price of the business that matters, but the terms of transaction as well. There are many variables that need to be considered in financing the acquisition of the business. Working out a projection can assist you in gaining an understanding of what will work for you.

Take action so you don’t become another story of a business owner who learns too late that they paid too much for their business. It is challenging to integrate a new owner into a business, to be accepted by customers, by employees, and by suppliers. You can avoid the additional challenge of having paid too much by taking two simple steps before you finalize your purchase.

1. Get an independent valuation
2. Prepare your own projections of cash flows

Ask your trusted advisor (lawyer, CPA, banker, other) for a referral to someone who can provide support for you

During a recent meeting to finalize a valuation engagement, my client asked me what could be done to reduce or eliminate the marketability discount. The quick answer is “nothing.” Then I had to explain why. After this experience, I realized that many business owners have this question, but most don’t ask.

The Discount for Lack of Marketability (DLOM) is probably the largest discount applied in determining the value of a privately held company and is appropriate in determining the Fair Market Value of a privately held company. The reason for such a discount to be considered is the lack of a ready market for the ownership of such a company. Marketability is the degree to which an ownership interest can be converted to cash quickly, without unreasonable expense, and with certainty as to the amount of sale proceeds.

The difficulty in identification of a buyer for a privately-owned business is a significant factor influencing the need for a DLOM. Even a 100% ownership in a small business is less marketable than the stock of a public company. Selling a small business requires considerable effort, time, and expense on the part of the business owner. In addition, the market for small businesses may vary significantly, which affects the actual selling price and terms.

A fully marketable business ownership interest is a publicly traded stock. You can call your broker to sell your shares, the price is determined based on the activity of the market and is publicly available. The transaction can be completed the same day, and the cash is available to you within three days.

A nonmarketable business is a privately held company that pays no dividends to owners and has restrictions on transfers of ownership.

There are three primary factors driving the marketability discount; time value of money, business risk, and variability of cash flow. Investors generally prefer liquidity – the ability to sell a business interest quickly – so steer clear of privately held companies. The situation is further impacted by the fact that most banks will not accept the ownership of a small business as collateral for a loan.

As part of the business valuation process, the appraiser has to determine not if a DLOM is appropriate, but how much of a discount is appropriate. There are several methods used to select an appropriate discount, including the restricted stock method and the IPO method. Both of these approaches compare stock prices for the same company with differing circumstances – when the stock is not publicly traded compared to when it is publicly traded. The DLOM is determined from the difference in these prices. There have been a large number of studies conducted, spanning decades, to assess the discount rate that would be applied to fully marketable value. The results of the studies vary, but the consensus is that the discounts range from 30% to 50%. These discounts have remained consistent throughout changes in the economy and overall market.

The analyst completing the valuation must look beyond the results of the studies to further assess the individual business on a number of factors. These factors influence the final discount that is applied.

The most significant part of the DLOM is determined through the application of an appropriate industry methodology, but a business owner does have some limited impact on the final DLOM, including:

• Financial performance
• Cash distribution policy
• Professional management (can the business run without the owner?)
• Restrictions on ownership transfer

These factors can decrease or increase the final DLOM and are typically considered after the analyst selects the more generalized DLOM based on studies and other factors that the business owner is not able to influence.

Finding a buyer who is interested in accepting this level of uncertainty presents the greatest challenge when selling a business and is the driving force behind the marketability discount. As a small business owner, your business value will include the application of a marketability discount regardless of all other factors that are considered in determining the value. You have limited ability to influence the discount level, so focus on building value in your business by making it a profitable business that will attract a buyer when you are ready.