The U.S. Small Business Administration (SBA) provides guidance in its Standard Operating Procedure (SOP) regarding the requirements for using SBA 7(a) loan proceeds to finance the acquisition of a business. In SOP, it states an independent business valuation from a qualified source must be obtained under the following circumstances:
The only instance where an independent business valuation from a qualified source is not required under SOP is if the amount being financed (including any 7(a), 504, seller, or other financing) minus the appraised value of real estate and/or equipment being financed is $250,000 or less.
The value of the business in an independent SBA-compliant valuation is to be determined under the Fair Market Value (FMV) standard of value. Under this standard of value, it is imperative to normalize the earnings of the business in order to conclude on the FMV of the enterprise. A normalization of earnings entails making certain financial adjustments to the historical income statement of the business being acquired such one-time, discretionary expenses, abnormal expenses, or otherwise extraordinary expenses are removed from a company’s financial performance.
FMV is largely a function of expected available cash flow, and the risk of obtaining such cash flow in the future. In some instances, the appraiser may use historical results as a proxy for the expected future performance. However, strictly relying upon the numbers reported on the company’s tax returns could severely understate or overstate the FMV of the business being sold. As such, the normalized cash flow of the entity being sold must be estimated by an appraiser.
In considering a hypothetical market approach, in which a 5x EBITDA multiple is considered appropriate, the difference in the concluded FMV of the business being sold can be seen with and without normalization adjustments:
|Payroll Taxes (7.65%)||1,913|
|Travel and Entertainment||10,000|
|FMV of Business (rounded)||1,500,000||1,784,563|
Perhaps the most common normalization adjustment made is to that of the compensation historically received by business owners or officers. The Officer of a company has the discretion to compensate themselves at any salary that is economically feasible given the performance of their business. To that end, appraisers must examine whether an Officer could obtain similar compensation from an unrelated employer while performing job duties similar to what is currently being performed for their existing business.
In determining the FMV of the Officer’s Compensation, the appraiser should at least consider the following factors as it relates to the Officer:
A common theme in smaller businesses is an owner who receives a salary but does not actively participate in the business. Under this scenario, it could be argued that the Officer’s Compensation should be completely removed. It is critical to understand the role and responsibility of the Officer prior to making any adjustments.
Typical sources of compensation comparability data are Economic Research Institute (ERI), Risk Management Association (RMA), U.S. Department of Labor, PayScale, Inc., and Salary.com. We note that ERI provides comprehensive data including the ability to sort information by job title, duties, industry, and geographic location.
In our example, we have concluded the owner is overcompensated by $25,000. However, an important adjustment remains. The adjustment to the compensation has an effect on payroll taxes and should be accounted for accordingly. A business is liable for expected payroll taxes at a rate of 7.65% of total wages under the FICA limit ($132,900 for 2019). Any compensation above the FICA limit is subject only to a 1.45% Medicare tax. It is important for the appraiser to adjust accordingly when historical or adjusted compensation is above the FICA limit. In our example, for simplicity sake, we have assumed the historical and adjusted Officer’s Compensation is below the FICA limit. Therefore, under this example, a reduction of 7.65% of the total compensation adjustment is required to reflect the payroll taxes expected to be incurred in conjunction with a FMV adjustment to Officer’s Compensation.
It is often typical in smaller businesses that the rent paid by the entity is below-market or above-market. A non-market rental rate is generally exhibited when the shareholder of the business being sold also owns the real estate in which the business operates. In these circumstances, the rent may be arbitrarily set to a rate that is not reflective of FMV. To align with FMV, the appraiser should adjust the rent to a figure which would be paid by the business to an unrelated party. In our example, we have concluded the FMV of the rent to be $15,000 greater than the rent historically paid.
As discussed earlier, the value of a business is based upon the expected future cash flows to be generated. Therefore, when using historical performance as a proxy for future performance, expenses which are not expected to reoccur in the future must be removed. Consider a situation where the business being sold incurred professional fees for an event that is not expected to reoccur in the future. An example of this could be a legal dispute in which the owner of the business being sold had to incur legal fees to settle the matter. In our example, we have concluded $20,000 in legal fees are non-recurring.
Similar to professional fees, there could be a situation in which the owner of the business being sold incurred a one-time repair expense. Consider a situation in which a building was damaged by a fire. The owner of the business may have had to pay for repairs as a result of the fire, but it can be reasonably expected that a fire would not occur again in the immediate future. In our example, we have concluded the $15,000 in repairs are one-time in nature and non-recurring.
Additionally, there is a tendency by private business owners to expense repairs, which should have otherwise been capitalized, to reduce taxable income. If this is discovered, the expense should be adjusted to a capitalized expense and the resulting depreciation expense should be forecasted.
The owner of a business may expense personal travel and entertainment to their business. These expenses have no relation or provide no return to the business being valued. Without this expense, the business would operate in the same manner. It is important for the appraiser to identify the nature of reported travel and entertainment expenses, and adjust these expenses if they are not related to the operations of the business. In our example, we have concluded that $10,000 in travel and entertainment expenses were not related to the operations of the business.
As shown in the example provided, using reported financial figures without any consideration to normalization adjustments may lead to an inappropriate conclusion of value. In reviewing business valuations prepared by independent parties, lenders should be cognizant of the aforementioned adjustments, as well as any other adjustments made and specified by an appraiser, since these adjustments could materially impact the FMV conclusion.
For questions, please contact a member of Withum’s SBA Valuation Services Group by filling out the form below.