Some difficulties in valuing small business (Part 1 of 2)

The main difficulty in valuing small business is the record keeping of the small business owner.  Since he or she is the proverbial “chief cook and bottle washer,” keeping the financial records is down at the bottom of the list in running the business.  In many cases, the owner keeps the business checkbook, bills and receipts and then dumps them all on an accountant’s or bookkeeper’s desk periodically.  From these “records,” the accountant is expected to prepare not only income tax returns, but all of the other reports necessary to stay in business.  Preparing accurate profit and loss statements is not high on the agenda.

It is important for business brokers, buyers and others who attempt to put a value on a small business, to keep in mind that financial records are prepared to minimize profits and, in turn, to reduce tax liabilities.  This is the opposite of what public corporations do, who attempt to maximize profits to impress shareholders and Wall Street.  In many small businesses, it is very difficult to establish their real earning power.  Small business owners are experts at “reducing” income for tax purposes.  It is important that the profit and loss statements (schedule C) be restated to reflect as much real cash flow as possible.  An in-depth interview with the owner may be necessary to reconstruct a true picture of earnings.  This must be done in such a way as not to implicate the owner in any questionable tax avoidances.  Owners may also try to point out that not all income is reported.  This is obviously illegal, and it can play no part in determining how much the business is really earning.  In other words, it has no place in the valuation process or in any subsequent marketing of the business.  If it’s not in writing, it does not count.

Another difficulty in valuing a small business is how much of the earning power is attributable to the owner.  In many small businesses, the present owner plays a significant role in the success of the business.  We recently talked to a good friend who was valuing a restaurant chain.  Present management, who has no equity interest in the chain, is showing gross sales and bottom line profit of 25 percent over similar operations.  This management is obviously doing a great job.  Is this business worth the same if management leaves?  (Remember they have no equity — or contract.)  We don’t think so.  Business brokers, valuers, and buyers have to take into account the present owner/operator.  He or she could be a real asset to the business, and a new owner could suffer the consequences.  However, new ownership can, and often does, increase business.  Small business is much more flexible and more easily influenced by new energy and enthusiasm.

 (Watch for tomorrow’s posting which will continue this article with some suggestions of considerations when valuing a small business.)