Business Valuation Analysis How to make sure independent appraisals are right on the money

Q: I'm in the process of purchasing an existing subchapter S corporation for which an independent appraisal has been completed. However, it appears that no consideration has been given in the valuation analysis to either the tax liabilities for the company (which are paid through distributions to the shareholders) or replacement salaries for the current shareholders (who are active in the business). Won't the exclusion of both or either of these factors lead to an unfairly optimistic valuation?

A: Before I address your specific questions, I'd like to state that valuation is more an art than a science. There are numerous ways to value a business, ranging from basic industry rules of thumb to discounted cash flow (DCF) analysis. The value of a business may vary significantly from buyer to buyer, depending on each buyer's own analysis of the value of the business. In fact, the same is true for valuation firms. Value may vary depending on the data used by the valuation professional, the methodologies used, the weight placed on the various methodologies and the overall interpretation of the data. As the purchaser of the business, you need to feel comfortable that the returns you're getting for your investment are sufficient for you to take on the risk of business ownership vs. another investment.

I'm assuming the primary method for valuation used in the professional appraisal of this business is DCF analysis, as is usually the case. If that's true, the cash flow being discounted is usually "free cash flow," which is the net of tax payments. Therefore, if the valuation didn't take into consideration tax payments, then you are correct that the free cash flow of the business-and thus potentially the value of the business-is overstated. Keep in mind, however, that pre-tax cash flow may be used in a valuation analysis (though this is not typical). This doesn't make the analysis incorrect. In such a scenario, the discount rate should be higher to account for the higher cash flow.

In addition, if the valuation relied more heavily on valuation methodologies other than DCF (such as an analysis of recently completed transactions of privately held businesses in the company's industry niche), pre-tax metrics may have been used. As long as the earnings multiples of the completed transactions were based on pre-tax earnings of the targets, the valuation is obviously correct to compare apples to apples by applying these multiples to the S corporation's pre-tax earnings. If metrics such as public price-to-earnings (P/E) ratios were used, then the use of the S corporation's pre-tax profits would be incorrect, as public P/E ratios use after-tax earnings.

With regard to your second question: In general, if the shareholders of the company are active in the business and will require replacement, then consideration should be given to replacement salaries for them. For example, if a buyer is planning to hire managers to run the business, the buyer should definitely take the replacement salaries into consideration, as the buyer's return on investment isn't calculated until after the management salaries are paid. Again, in a DCF analysis, it is common to take replacement salaries into consideration when calculating cash flow. If salaries are not taken into consideration, the discount rate should be increased accordingly.

Keep in mind, however, there are valuation methodologies, primarily for smaller companies, that are based on the entire return to the shareholder, or profits before owners' compensation. If you're going to be active in the business, you need to feel comfortable including your compensation as part of the return you'll receive on investment.

The approaches you mentioned that were taken by the appraisal firm are not necessarily incorrect, but you're right in considering these factors when completing your own analysis of the business. Again, you need to feel comfortable with the overall return you'll get for your investment in the business-that will produce the correct valuation for you.

Loraine MacDonald is director of advisory services at USBX, an investment banking firm specializing in the mergers and acquisitions of small to midsized businesses. She has been involved in the valuation and sale of privately-held businesses for over ten years. She can be reached at lmacdonald@usbx.comor at (310) 315-6700.

The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.