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Valuations by Brokers

Are They Credible and Objective?

Why Business Valuations Prepared by Business Brokers are Suspect. We are not a business broker who provides an inflated “business valuation” to convince a seller to list the business with us.

We do not employ business valuation analysts within a division of a business brokerage firm to camouflage our true business or disguise our actual intentions.

We perform qualified, independent and objective business valuations according to professional business valuation standards which require, among other things, that we have no past, present for future contemplated interest in the business we value.

The Difference Between Purchasing a Business and Purchasing a Job. Just because you’re self-employed, doesn’t mean you own a business.

The distinction between these two concepts is the basis of much of the misinformation about small business ownership. The false concept is promoted by business brokers to sell businesses and earn commissions.  They are the cause of lifelong disappointments, heartaches and financial ruin of uninformed hopefuls who were seeking financial freedom through pursuing the American Dream.

Here is a good workable definition of a true business:

“A business is an economic activity which earns a profit for its owners above the fair value of the owner’s services, provides returns on the owner’s invested capital high enough to compensate for the company-specific risk, and can operate independently without the presence or subsidy of the owner.”

Anything else is likely to be a job. These “businesses” are frequently a means to employ their owners, often for long hours, requiring very hard work for a very long time, often for sub-standard pay and usually providing sub-market or no financial return on invested capital. Small business rules don’t usually make economic sense, so sooner or later, small business owners realize the trap they’ve created for themselves, and abandon their hopes for financial freedom.

A competent business valuation by a qualified, independent, objective valuator can prevent purchasing a financial and personal nightmare disguised by a broker as an opportunity for financial freedom.

The Business Broker Mentality. Many brokers depend on misinforming potential buyers by emphasizing “adjusted net” profitability. This is a misleading theory based on adding back the owner-operator’s salary and fringe benefits to the real profit to produce an artificially higher profit, disregarding the market value of the owner’s services provided to the business. They are, in many ways, “dressing a pig as a princess.”

Business Brokers – The Continuing Deception. The misleading part is that the business is sold on the false notion that the “adjusted net profit” is likely to be the result of purchasing the business. Nothing could be further from the truth. No small business can run without the services of a manager, the role usually assumed by the owner. This is the owner’s job. Someone has to pay for this function, and it must be paid by the business to survive.

  • Example 1. A cleaning store requiring the services of the owner, requiring an investment of $100,000 purchase price, whose “adjusted profit” is equal to the value of the owner’s services is not a business. It’s a job producing no business profit nor return on the owner’s invested capital.
  • Example 2. A pizza restaurant which provides an “adjusted profit” of $50,000, but requires its owner to be the manager, whose fair value $70,000 per year, is not a business. It’s a job which loses $20,000 per year.
  • Example 3. A machine shop, which earns a “profit” of $100,000 a year, requiring an owner or manager to operate the business, whose fair market salary value is $70,000 and whose invested capital requirement is $1,000,000, is not a business. Its $30,000 profit doesn’t cover the cost of invested capital.

    Even the least risky business investment requires a return on invested capital of at least 15%. Total invested capital of $1,000,000 requires a risk-adjusted investment return of at least $150,000.

    (You could invest the same $1,000,000 capital in a bank CDs and earn $50,000 per year in interest with no risk, get a real job for $70,000 a year, have no worries and be $50,000 better off.  Or, you could invest the money in a moderate risk, diversified stock portfolio and earn an average long-term rate of 12%. Why would you buy this “business” with additional risk and tolerate a sub-standard return on investment?)

    When you consider the required return on invested capital, the business “adjusted profit” of $30,000 costs the owner $120,000 per year over an alternate investment.  That means, this owner loses $10,000 per month in this “business” investment.

  • Example 4. When a buyer pays $100,000 for a “business” with an “adjusted net” of $50,000, the buyer paid twice the annual salary for his “job.” The buyer must work two years for “free” to earn back his $100,000 investment until he can “earn” $50,000 in salary in year 3.

    Moreover, he earns nothing on his investment of $100,000 for the entire time he owns the “business.” At a minimum equivalent return on investment in a risky small business at 20%, his $100,000 invested in legitimate business should have earned $20,000 annually.

    If he owns the business 5 years, he has forfeited $100,000 in investment returns and worked for five years at a $50,000 job.  If he sells the business to someone else later, he may recover his original $100,000 investment, again, usually with no investment returns. Then, the cycle starts over again with the new business owner. And so on.

    If the business cannot produce a profit above the owner’s equivalent salary, it is not a true business. Although the owner is self-employed, and he won’t fire himself, he is still simply buying a job.

Business Brokers – Involved From Birth to Burial. Business brokers are the first to flaunt the benefits of ownership when they’re talking to buyers, and charge the seller up to 10% of the sales price to sell this “unique opportunity.”

Later, when the owner realizes they’ve been duped into a thankless profitless job, they contact a broker to sell their “slave job” to yet another unsuspecting hopeful as a “unique business opportunity,” again, charging the seller up to 10% for finding a replacement buyer. And, so on, until the last owner closes the doors permanently.

Legitimate credentialed business valuators must certify they are independent, objective and have no prior or contemplated business dealings with any party to the transaction.

Business Brokers – Biased Business Valuators. Not satisfied with their disreputable business reputation, business brokers have imagined themselves as business valuators, on the self-appointed notion they “know best” how much a business is worth based on a series of questionable sales transactions on an overvalued “business” which keeps changing hands between successive uninformed business buyers.

Business brokers are not qualified as legitimate valuators. Moreover, they are not independent, as many of their “valuations” are grossly overvalued, designed as sales gimmicks to obtain listings from hopeful sellers who are desperate to recover their original investment and escape from their slave “job” ownership responsibilities. This cycle may repeat many times over several successive owners.

Legitimate, accredited valuators are required by professional standards to be unbiased, independent and objective in their value conclusions.

Business Brokers – Not Phased by the Facts. Despite a long string of overvalued sales transactions to unsuspecting buyers, brokers do not follow any generally accepted business valuation methodology or theory. In fact, most brokers will rely on their string of unsuccessful sales transactions as evidence of their qualifications as “real world” valuation experts.

A true valuation takes into consideration a “realty test,” the very procedure employed to detect an over-valuation. It tests real world realities with the value conclusion to determine if the estimated value is realistic in the long run, or if it “pencils out” considering alternative investments in other equivalent business opportunities.

Business Brokers – What They Don’t Want You to Know. Business brokers must keep potential buyers away from legitimate valuators to prevent their prospects from learning the truth about business value.  Most of the businesses for sale are “dogs” run by burnt-out owners seeking relief from their dog-day “jobs” earning sub-standard profits as business owners.

Why in the world would someone want to pay money for a dog-day job?  Only if they don’t realize the benefits do not justify the burdens.  Only if they are mislead by the brokers’ sleight of hand on the so-called “adjusted net” profit swindle.

Business Brokers – Dependent on the Uniformed. Many business brokers rely on unsuspecting business buyers who do not know how to value a business. The broker asserts her “expertise” and offers a “business valuation” to a buyer, while instructing the buyer to avoid the expensive or unnecessary services of a legitimate valuator.

  • Targeting Immigrants. Many brokers specialize in selling businesses to immigrants, many who arrive with abundant available cash and a strong willingness to work hard.  Unsuspecting and uniformed, new arrivals are optimistic about employing family members in place of former paid employees, especially in jobs requiring little or no technical skills.  They employ the entire family without pay, thus avoid payroll taxes, overtime, disability insurance, other fringe benefits and workman’s’ compensation insurance premiums.
  • Culture Clash and Transition Risk. Often from third-world countries, immigrants naturally resort to familiar business practices and ethics principles from their home countries, and thus encounter potential culture-clash issues when dealing with an assimilated, Americanized customer base, adding further risk associated with transition of the business from the prior owner, usually causing a longer transition time and requiring more capital to invest to cover sub-standard profitability or outright losses.
  • Stubborn Imposition by New Arrivals. In some cases, stubborn new arrivals insist on superimposing their familiar values upon the business, and enforce changes on the customer base which alienates them, causing the business to falter or fail outright. Sometimes, reason prevails, and failing businesses are listed with a business broker to sell before the inevitable doom. The business broker, then, “dresses a pig for the prom” and lists the business as an “exceptional opportunity for the right buyer,” meaning, if you buy it now at this very special price, you can work very hard and turn this “pig into a princess.”
  • Avoiding Culture Clash Diminishes Value. To avoid potential culture clashes, brokers will offer business which cater to the ethnicity of both the buyer and customer base, such as an Armenian grocery store in an Armenian neighborhood. Trouble is, the value is diminished because the business is limited to Armenian-based owners who speak Armenian, located only in Armenian neighborhoods, catering to mostly Armenian customers. Who but Armenians would be potential buyers of this business? The same goes for a Jewish deli in a Jewish neighborhood.  Limiting the potential pool of buyers increases uncertainty and risk of finding a suitable buyer, lengthens selling time, and thereby, diminishes business value to compensate for the additional uncertainty and risk.

    The special situations which limit buyers and sellers are often referred to as investment sales, not financial sales, and these distinctions are rarely, if ever, considered by brokers when estimating business value.

  • Pricing Premiums for Low-Tech Cash Businesses. Moreover, low tech, cash-based businesses are especially prized and sell for a premium price because of their opportunity to avoid taxes by under-reporting income. This practice continues despite warnings that unreported income cannot be considered when selling the business to a successive buyer.
  • Little Due Diligence. Immigrant buyers are especially prized by brokers because of their low threshold for due diligence, their available capital and their propensity for hard work to overcome financial disadvantages of many small businesses for sale.
  • Narrowing The Target Market. Many business brokers are themselves new arrivals and specialize in selling businesses to fellow immigrants of the same ethic background, thereby intensifying and narrowing their target market to those of similar core values and ethnic belief systems.
  • Poor Valuations Resulting From Broker Guesswork. Trouble is, business brokers rarely make distinctions regarding these valuation issues when “valuing” a business, dismissing or disguising these issues, or leaving it up the buyer to accommodate these significant reductions in value caused by limitations in transferability of the business from one owner to the next.
  • Disappointed Buyers’ Exit Strategy. If the buyer is disappointed, no worries. They can always attempt to sell the business the next available buyer by contacting, you guessed it, the business broker. It will generally cost the seller a commission of up to 10% and take as long as six months to a year to sell the business, if it sells at all. In the mean time, the owners have to keep the business running to appear as though to a potential buyer, that their business is a “princess at the ball.”