Business appraisals are not an exact science. A business appraisal can result in a fairly wide range of value, rather than a single number. The appraiser’s approach is likely to be influenced by the reason an appraisal is needed, past history, future prospects (an educated guess, at best!), industry comparisons, whether the appraisal is of a minority or controlling interest, marketability of an ownership interest, and various other factors.
There many situations for which the business owner will want the lowest possible value to be attached to the business, while whoever is on the “other side” will want the highest possible value. And vice versa!
There are a handful of simple approaches an appraiser can use to bias the value results downward:
- Put weight on low-performing periods when calculating the weighted average revenue and earnings.
- Use high cap rates and discounts rates, and use low value multipliers.
- Use pessimistic projections.
- Exclude methods that give high values.
Ideally, an appraiser can find unbiased, realistic, defensible settings which will be disliked equally by both sides. But in practice, situations can be encountered where the appraiser has blatantly pushed the limits of credibility.
Here’s an example of how a valuation can be biased so far to the low end that it’s almost funny, except for the extreme lowball effect on the departing shareholder’s payout. Or vice versa, if you’re on the other side.
You may remember that the auto industry had a very difficult time in the 2008-2009 recession. A particular dealership, like many of its counterparts, had low sales and big losses. But the auto industry has been steadily improving since, and the dealership’s current outlook is pretty good. Results had been improving steadily to a very nice profit in 2012, and the future looked rosy.
For an appraisal, this question arose: how much weight should be put on each year from 2008 through 2012? A departing shareholder’s payout depended heavily on the answer. Bear in mind that the idea of using historic data is intended to help estimate a sustainable earnings number that a buyer might expect over the next few years.
The appraiser for the remaining shareholders at the dealership put equal weight on all five years, giving the 2008 results the same relevance as the 2012 results. Further, he made no add-backs for shareholder perks, and omitted some other critical factors, without explanation.
This resulted in an estimate of annual “sustainable earnings” of about $200K, compared to $1.2 million earnings in the latest year. He used the $200K number to calculate the value for the departing shareholder’s interest, and he did not use future earnings methods. He then capped this off with a 50% discount for lack of marketability. For most appraisers and business owners, these are classic lowball techniques, and would likely be subject to a “fairness objection.”
Sure enough, the appraiser for the departing shareholder put all the weight on just the last two years, assumed all the add-backs that the first appraiser had omitted, relied heavily on happy projections, and used no marketability discount (remember, all those buyers are
sitting right there). The net effect was a value that was roughly 10x the first appraiser’s value. Astounding and well outside typical norms! Needless to say, the departing shareholder was pleased with this outcome; the remaining shareholders, not so much.
At that point, as part of many transactions, some nominally equitable method of resolving the wide discrepancy in assessments. A third appraiser, more independent than either of the first two, might be the best solution.
[Our thanks and appreciation to Hans Schroeder of BAER for the above info.]
The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.
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