Selling the Mom & Pop Business: Cap Rates and Cash Flows - Determining the FMV of a Small Business in Receivership By Cavanaugh, Kevin* A basic question must be answered when evaluating a proposed sale of any
fiduciary-controlled asset: “Does the proposed sales price equal or exceed
the asset’s fair market value?” Granted, these are utopian circumstances. In most situations there may be uneven access to information about the item being sold, some need to sell (or purchase) quickly (even at a discount or premium), and similar intervening circumstances. It is worth noting that if a sale were to occur in these utopian
circumstances, the parties more than likely would have arrived at the same
notion of FMV based upon vastly different assumptions. A representative
illustration of such convergent calculations is presented later in this
article. In the case of a small business, the cash flow/economic benefits as stated in its financial statements are rarely useable as-is to determine the normalized economic benefit. The information in the financial statements should be adjusted to take into account real-world aspects of the proposed transaction, such as related-party transactions (bargain sales), owner compensation issues (over or under the market), nonrecurring items (one time spike in the price of the goods produced), non-operating items (condominium at a resort area) or other extraordinary items. Once the normalized economic benefit is calculated, the receiver (or receiver’s accountant) must develop a risk-adjusted rate of return. This rate is determined based on alternatives available in the marketplace. Alternatives include long-term bonds (relatively risk-free historic return 5% annually) and the stock market (somewhat riskier historic return 12% annually). Based on the logical assumption that investing in a small company carries more risk than either investing in bonds or the stock market, professional judgment must be applied to determine the appropriate risk-adjusted rate of return commensurate with investing in a particular small business. Briefly stated, the greater the risk of achieving desired returns, the lower the fair market value should be. Back to Our Utopian Illustration On the other hand, the hypothetical Buyer notes that the Seller employs his own son-in-law in the business who the Buyer believes is being paid $100,000 over market for his services. Therefore the Buyer’s normalized cash flow for this small business would be $400,000 – the $300,000 annualized cash flow used by the Seller plus the additional $100,000 the son-in-law is being overpaid. Further, our hypothetical Buyer has a more conservative view of the risks associated with this business and assigns a risk-adjusted rate of return of 33 1/3% (rather than 25%) to the normalized cash flow. The Seller calculates FMV by dividing the annual cash flow of $300,000 by a .25 (twenty-five percent) cap rate, which yields 12,000.00 — a projected FMV value of $1,200,000. The Buyer’s calculation is $400,000 divided by a 33 1/3% cap rate, which also yields 12,000.00, or a projected FMV of $1,200,000. Although the Buyer and Seller were working from different value and cap rate assumptions, they reach the same calculation of FMV. The result is that, hypothetically, the asset changes hands. Summing Up In the real world many different approaches may be utilized to determine the FMV of a small business. The results of these different appraisal methods are then weighted differently, based upon the appraiser’s professional judgment as to which method is most appropriate given the reliability of the available information. As can be seen, determining FMV is a complex art. But with
well-substantiated reasoning for the assumptions used and an understanding
of normalized cash flows and risk-adjusted rates of return, a sound
calculation for a small business’s FMV can be made and persuasively
defended. |