The approaches to valuation are as varied as the type of transactions. No one method is suitable for every type of acquisition. Special situations require their own unique approach
Valuing the Insolvent Company: More than a few insolvent businesses are acquired under Bankruptcy, receivership or foreclosure proceedings for purposes of rehabilitation for continued operation.
Although the buyer may view the profit or turnaround potential as the motivation for the acquisition, the future profitability is not the criteria for determining value. Instead, the buyer should approach valuations from the seller’s perspective, which is to liquidate the assets at auction. Where other interested buyers are bidding for the business, the competition may influence the price upwards, however, each will nevertheless use liquidation values as the basis for negotiating.
Frequently, a buyer will be offered an insolvent business not yet under formal insolvency proceedings. In this situation the seller may arbitrarily set the price to match the proceeds needed to liquidate the debt. The price will, of course, bear no relationship to the actual value of the business
The proper approach in this situation is to encourage the seller to enter into formal insolvency proceedings, with the buyer acquiring the business at liquidation values. As an incentive to the seller, the buyer may offer the seller personal compensation in the form of a covenant-not-to-
compete, a contingent pay-out as a percentile of future profits, or perhaps only the opportunity for employment.
Valuing the Service Business: Service businesses, aside from selling normal fixed assets, rely on their primary asset.
The difficulty in establishing a value on such businesses as professional practices, brokerage firms and service trades, is that sales and good will are so closely tied to the existing relationship between the seller as an individual and the customer. Once the business or practice is sold, many of these same customers will discontinue patronage.
The traditional approach in valuing the service business is to set a price equivalent to a certain percentage of future sales generated by the acquired customer list. Tangible assets may be valued separately.
The percentage of sales reserved as price will depend on prevailing industry custom, but generally is reserved to between 15% to 35% . The pay-out is ordinarily limited to between 3-5 years on the premise that continued patronage beyond that time is due to the new good will created by the buyer. There are, of course, instances where the buyer will acquire the accounts and customers’ lists for a set price. However, even in this situation, the price is determined by the anticipated future sales.
Where the seller agrees to a contingent pay-out, the seller’s concern will be on the ability of the buyer to retain the good will and maximize the sales on which the contingent price shall be based. Additional concerns will be the safeguards to define earnings and insure the payment of the contingent pay-out.
Valuing the Merged Business: When the acquired business is to be dismantled and functionally merged into the buyer’s business, the buyer cannot base the value on the profitability of the business as an intact organization. The only approach is for the buyer to translate the economic benefit of the merger on his own income statement.
This requires a careful analysis of each of the operational changes resulting from the merger and an equally carefully reconstruction of the buyer’s profit and loss statement.
The functional merger may produce a synergistic effort on the buyer’s profits where the combined profits will be greater than the profits of the two separate organizations. With less frequency, the greater profits will be achieved by operating the two firms separately.
From the buyer’s viewpoint, the functional merger or absorption may justify a higher value then would be justified by operating the acquired company separately, However, this subtle benefit to the buyer rarely enters into the negotiation.
Valuing the Business with Real Estate: Motels, hotels, nursing homes and similar businesses which feature real estate as the primary asset should be valued as business operations rather than passive real estate investments.
Frequently, a seller will offer commercial property together with the business package price. In this situation you must appraise the real estate and business separately. The starting point is to determine the fair rental value of the premises occupied by the business and from this extrapolate the appraised value of the real estate. A licensed real estate appraiser can accurately set a value.
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