Usually a professional appraiser will seek input from the current owners when he or she is valuing a business. They want to get the inside scoop on how the business works, and it is an important part of the appraisal process.
Valuators need not only knowledge related to valuation principles, but also a thorough understanding of the business itself and what drives its value. It’s natural that they would get this understanding from the people who own and operate the business.
Stick to the Facts
When an appraiser is interviewing company insiders during the valuation process, they need to focus on fact. It can be difficult for a business owner to do this and not inject their own opinions and personal expectations. Small business owners have invested a lot of blood, sweat, and tears to grow their business, and staying factual can be very hard.
For example, a common part of a business appraisal is whether or not compensation paid to the owners and executives seems reasonable, based on comparisons of other similar positions. To do this, the business owner needs to examine salaries from perspective of an unbiased third party. Would a hypothetical investor think the current compensation rate was acceptable?
A Closer Look at Owners’ Compensation
Many business owners have worked so long for themselves that they lose touch with current compensation levels. Sometimes they overestimate their contributions to the business and write themselves paychecks whenever they need cash. Conversely, others underestimate what their contributions are worth and don’t pay themselves enough.
Downplaying salary expense is common among S corporations and other pass-through entities that can take distributions tax-free. S corp owners may attempt to minimize owners’ compensation expense to avoid paying payroll taxes.
The reverse is true for C corporations. They may overstate owners’ compensation to avoid paying double taxes on corporate dividends.
From a valuation perspective, this is an important issue, because it’s a large expense that can have a big effect on value. Taking cash away from a business in the form of excessive owners’ compensation depletes its value. The opposite is true for underpaid executives. The company’s working capital is freed up and its need for debt is diminished, which, in turn, gives the company an opportunity to add value.
Other Subjective Elements
Reasonable replacement compensation is just one example of operating issues that owners may lack objectivity about. Owners also sometimes overestimate how integral they are to customer relationships, arguing for substantial key person discounts. These discounts are warranted in rare instances when a large number of customers wouldn’t transition to a new owner, when the company has little or no succession plan in place, or when the owner possesses unique skills and experience that would be difficult for a replacement to replicate. Usually, however, these factors are not applicable.
During the appraisal process, some owners are surprised to discover that some customers might be tied to one or more employees. Businesses that don’t have valid noncompetition agreements with key employees might be worth less than the owners think.
Garbage In, Garbage Out
It’s true that business owners are a necessary part of the valuation process. But while owners have intimate knowledge of the business and its strategic plans, they need to look at the company through the eyes of an investor. If they are unable to do this, the appraiser’s conclusion may be skewed. To learn more about the business owner’s role in valuations, call Filler & Associates.