Fall 2006 • Issue 23, page 6

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?”

What Is Fair Market Value?
To answer this question, we must first define fair market value (“FMV”). FMV is said by economists to be the hypothetical cash equivalent consideration for which an asset will trade hands in an open and unrestricted market, where the market consists of reasonably informed, willing and able buyers and sellers who are acting at arms-length with neither buyer nor seller under any compulsion to trade.

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.

Calculating FMV
The most common method to calculate FMV is to determine the normalized economic benefit (a/k/a “normalized cash flow”) and apply a risk-adjusted rate of return (capitalization rate). “Normalization” means to project cash flow in the absence of any unusual events, related-party transactions and / or any other extraordinary items that might skew the cash flow. The capitalization rate is a number which, when applied to the cash flow, yields a projected return on investment sufficiently large to entice an investor/buyer. The greater the perceived risk of any investment or purchase, the greater the cash flow from the investment or purchase must be.

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
Now it is time to return to our utopian transaction for a simple illustration of how different FMV assumptions arrive at the same FMV. Assume that the Seller has correctly calculated that his small business is generating an annual cash flow of $300,000. As the Seller/Owner, he/she has a personal bias. He/she will likely be aggressive, setting an asking price for the asset based upon a risk-adjusted rate of return of only 25%. This means, in essence, that the Seller/Owner has a higher opinion of the value of the asset than does the market. This is why homes are usually initially priced higher than their ultimate selling prices.

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
Though our example is rather simplistic, it generally reflects the broad market for small businesses. Most small businesses sell for between three to five times cash flow, suggesting a risk-adjusted rate of return assumption of 20% (five times normalized cash flow) to 33 1/3% (three times normalized cash flow).

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.

*Kevin P. Cavanaugh, CPA is the Managing Director of Douglas Wilson Companies’ San Francisco office. He is a licensed real estate broker in California and Florida and is a November 2006 candidate for the American Institute of Certified Public Accountants “Accredited in Business Valuation” designation.