When reviewing a business valuation report, an attorney should check to see that the business appraiser considered the three approaches to value—market, income, and asset. While each approach has its own methodologies, our focus in this blog will be on the market approach, and specifically, how to review the guideline transaction method.
In a business valuation, the guideline transaction method requires an appraiser to search transaction databases to identify actual completed sales of similar businesses. This data can then be used in the appraiser’s analysis and determination of the value of the business.
Consider this hypothetical: A married couple, one a chef and the other a restaurant manager, see an established restaurant is for sale in their neighborhood that they would like to own and operate. They approach the seller and learn that the asking price is $1 million for a 100 percent controlling interest in the entity’s equity. The seller represents that the restaurant had $1 million in annual revenues the prior year and generated a gross profit of $250,000. The asking price implies multiples of about 1x revenue and 4x gross profit.
To determine if this is an appropriate price, they hire a business valuation consultant. The consultant reviews completed transaction data and determines that the multiples based on revenue and gross profit are reasonable. The couple purchases the 100 percent equity interest in the restaurant at the asking price.
What was bought and sold?
Under the guideline transaction method in business valuation, there are two types of transactions that may appear in transaction databases, stock and asset. The example presented above illustrates a stock transaction, typically in which all operating assets and liabilities are transferred from seller to buyer. However, what consideration would have been needed if an asset sale of the restaurant had occurred? What would be transferred to the buyer? What would the seller keep?
Stock transactions are relatively straightforward. Asset transactions, on the other hand, can create complications if not used properly, because they generally represent the transfer of only certain assets (e.g., fixed and intangible assets). In these instances, the multiple does not include cash, accounts receivable, inventory, or any liabilities. In both cases, however, an appraiser will apply a selected revenue or earnings based multiple to the appropriate financial metric of the company being valued. The illustration below provides the general difference between application of stock and asset transaction multiples.
How, then, does one know which assets were bought and sold? For asset transactions, a purchase price allocation is required, which is often disclosed in the databases and identifies what was bought and sold. It is then the appraiser’s responsibility to find the lowest common denominator of all asset transactions, in order to make them comparable for analysis. This is done by removing any assets or liabilities from the transactions that do not appear in all transactions, and adjusting the indicated transaction price by the assets or liabilities removed.
If no purchase price allocation is available, or it is unknown which assets were purchased and which liabilities were assumed, then an appraiser may decide to disregard the transaction.
Issues to Consider
When reviewing a business valuation report which includes the use of the guideline transaction method, here are some issues for an attorney to look for and consider:
• Make sure that any transaction multiples used were from transactions that occurred before or up to the date of valuation.
• Are the multiples used in the method from stock transactions or asset transactions? (it should not be a mixture of both unless the values from each are presented separately and reconciled).
• Which databases were used? Does the appraiser’s report explain the source of transactions for each database used and what the transactions from each database purport to represent (there are differences between the databases of which an appraiser must be aware)?
• What multiples were used to value the subject business? Were the multiples applied to the correct financial metric of the business being valued?
• Do the transactions the appraiser selected appear to be for reasonably comparable companies? Were adjustments made to the guideline transaction multiples to make them more comparable?
• With respect to the use of asset transactions, did the appraiser appropriately adjust for the assets that were actually sold?
• If the valuation is for a minority interest in the business, was the value indication derived from the guideline transaction method adjusted for the appropriate discounts?
• Was the value from the guideline transaction method reconciled to values from the income and asset approaches? If there is a wide variance in value between the value indications from the guideline transaction method and an income approach, this may indicate:
- Use of transactions of companies that are not comparable to the subject company
- Use of non-relevant multiples for the specific industry
- Application of multiple(s) to incorrect financial metric(s) of the business
- Indiscriminate use of average or median multiples
- Failure to apply appropriate discounts
- Failure to adjust for deal terms and structure
One final note: The guideline transaction method is distinguishable from another market approach, the guideline public company method, which represents the transfer of non-controlling, or minority, interests in the public markets. Though there are ways to bridge the gap between these two methodologies (i.e., the application of a discount for lack of control), we will save that information for a future blog.
FSS utilizes many of the sophisticated transaction databases available to business appraisers for the guideline transaction method. To learn more about guideline transactions, stay tuned for additional blogs on the topic. In the meantime, please contact us with any questions.