I recently attended a firm sponsored seminar on business valuation where one of the presenters was Sandra Klevan, a seasoned expert in the field who is affiliated with Financial Research in Bala Cynwyd, PA.
One of the subjects Sandy touched upon was the importance of the management interview to the valuation process. In an effort to manage costs and, in some instances, out of pure arrogance, some business appraisers will either severely limit or even skip this highly important step.
A business appraiser’s function is to estimate what an enterprise will sell for in the open market where buyer and seller have the freedom to negotiate. The typical business appraisal involves the appraiser pretending that he or she is a potential buyer. In a sentence, the opening question is: “What do I get if I buy this business?” Obviously, the principle driver of what any buyer is looking at is derived from study of the tax returns and financial statements issued for the business. But as the Pennsylvania courts have often acknowledged, these financial records can often obscure rather than illuminate highly important facts.
The typical interview involves the appraiser asking management questions such as:
- How does the business secure customers and what induces them to stay or go?
- How is the business managed in terms of both its organization and its personnel?
- Who constitutes the competition and what makes the target company competitive or not?
- Have there been transactions involving sale of ownership interests and on what terms were they effected?
Let’s take these questions and provide some playful, yet not unrealistic answers. Let’s assume the business is a small convenience store where customers can purchase everything from batteries to milk and eggs. The business has been at its location for more than 40 years.
- Obviously, the business secures its customers because it provides convenience. This can often yield higher profits because these stores typically emphasize that convenience. The advantage of these stores is almost entirely geographic.
- Let us say that the business is run by the same guy who started when it opened 40 years ago. He knows and grew up with many of the people living in the neighborhood. Like the town post office people often stop in to find out what is going on the in the neighborhood and when they stop there is usually something overpriced they will need and buy. But seller wants to retire to Florida so the new buyer is not going to be a conduit for information and new buyer is not interested in promoting the “town hall” concept.
- Profits from this business on a historic basis are great. But Wawa, Landhope, or one of the other chain convenience stores is opening four blocks north where you can get sandwiches and gasoline. Construction permits have been issued. Oh yes, seven blocks south, Target has filed an application to build a 60,000 square foot store with on-site parking.
- Twelve years ago, owner bought out his father who started the business to give current owner a job. Son effectively paid, 2x net profit as reported on his father’s tax return. Do you get it? These facts really do change the playing field. This is a tired old business which still reports great earnings but it is facing competition that is likely to overwhelm it in the next 2-5 years. The goodwill of the business is arguably built around the 60-year-old guy behind the counter who is packing for Tampa. And if I want to buy overpriced AA batteries and a quart of skim milk, why not do it when I am getting gas and a meatball sandwich. The advantages of the business are there on the tax returns but the future looks bleak. Past is not always prologue except for Shakespeare. If your appraiser comes to court and testifies to value without knowing these facts, the cross examination will be brutal. We live in an age when things change fast. If you doubt that reality, ask the bondholders for the Revel Casino or anyone else who invested in Atlantic City in the past decade. Cold accounting papers often do not reveal hot trends that can make or break a business despite a long history of success. If you disagree I encourage you to hop over to your neighborhood Blockbuster and watch a movie while your appraiser finishes his report. Oh, never mind.