The SBA business valuation and SBA business appraisal community has developed norms about what we believe is expected by the SBA based on the SOP’s and customs for valuing small businesses.
While the SBA 7(a) loan program can provide loans up to $5,000,000 most SBA business valuations are for smaller businesses with revenues in the $500,000 to $2,000,000 range. Different methods are used to value smaller businesses than larger businesses. I will cover some of the more popular valuation approaches used in SBA business valuations and appraisals.
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Asset Method. The asset method is rarely used as the primary valuation method because it looks to physical assets to by conveyed (generally equipment and maybe inventory in smaller businesses) and does not easily calculate intangible assets such as goodwill. For SBA business valuations the SOP suggests using Tax Basis asset values as opposed to marking the assets up to market value. If a banker wants to use market value of the physical assets they need to obtain an equipment appraisal. Traditionally the SBA required down payment varied with the amount of goodwill so bankers requested that the goodwill be estimated on this basis. That may not be necessary (it may vary by bank policy and underwriter desires) with the new SOP where all loans may qualify for 10% down payment treatment.
Income Methods. Income methods are the most popular and considered the best indicators of value by the valuation community. Yet, due to the small size of most SBA financed businesses for SBA purposes the Income method is not the prefered method. This is because the income method specifies that it is the value “to an investor”. Many smaller businesses have value to an owner/operator but do not generate enough earnings to have value to an investor also.
In both income methods the cash flows explained below are applied against a discount or capitalization rate calculated using a “build-up method” often based on data from Duff and Phelps Navigator.
That said, there are two primary income methods. The Capitalization of Earnings method looks at the past earnings stream and uses it to estimate the cash flows in the likely foreseeable future. It makes the most sense when earnings are fairly stable and expected to remain that way. When the business is large enough this is the preferred method for SBA business valuations.
The second income method is call the Discounted Cash Flow. This method uses a projection and the future cash flows from the projection used to estimate the future cash flow. Projections can be subject to manipulation and are unproven in any case therefore this method is only used with start-ups and turn arounds where projections can be strongly supported and are also approved by the bank receiving the SBA business valuation.
Market Methods. The market methods look at various historic cash flows typically from the last three years and compares them to the information presented in transaction databases and other sources of transaction information like Pratt’s Stats. Other sources of transaction information can be public filings like EDGAR on line or local knowledge if the appraiser knows local brokers. Typically revenues and discretionary earnings are used as the comparison cash flows although there are many other cash flows the can be compared depending on the industry, company size and other factors.
The calculated cash flow is then compared to the cash flows and recorded sales prices from comparable business sales. There is a lot of variance in how transactions are reported. In general it is felt that averages or values based on multiple transactions will produce a better “multiplier” which is applied to the cash flow to calculate the value. Every valuation annalist has a different way of estimating the multiplier to use in any given case but it usually involves comparing the profitability of the business being valued to the range of reported profitability of the comparables.
Due to the size of the companies being valued for SBA business valuations the market method is the most popular method. In business valuation the individual annalist must determine the most appropriate method and it will vary at times but most of the time SBA business valuations are based on the market method.
In summary generally the market method is used for SBA business valuations. Most valuators have also used the asset method using tax book values to estimate goodwill and intangible assets for the bank also.
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